People have become increasingly dependent on credit. Therefore, it's crucial that you understand personal credit reports and your credit rating (or score). Here we'll explore what a credit score is, how it is determined, why it is important and, finally, some tips to acquire and maintain good credit.
SEE: 3 Ways To Improve Your Credit Score
What Is A Credit Rating?
When you use credit, you are borrowing money that you promise to pay back within a specified period of time. A credit score is a statistical method to determine the likelihood of an individual paying back the money he or she has borrowed.
The credit bureaus that issue these scores have different evaluation systems, each based on different factors. Some may take into consideration only the information contained in your credit report, which we look at below. The primary factors used to calculate an individual's credit score are his or her credit payment history, current debts, time length of credit history, credit type mix and frequency of applications for new credit. Because the scoring systems are based on different criteria which are weighted differently, the three major credit bureaus in the U.S. (Equifax, TransUnion, and Experian) may issue differing scores for an individual, even though the scores are based on the same credit report information.
You may hear the term FICO score in reference to your credit score - the terms are essentially synonymous. FICO is an acronym for the Fair Isaacs Corporation, the creator of the software used to calculate credit scores.
Scores range between 350 (extremely high risk) and 850 (extremely low risk). Here is a breakdown of the distribution of scores for the American population in 2003:
What About A Credit Rating?
In addition to using credit (FICO) scores, most countries (including the U.S. and Canada) use a scale of 0-9 to rate your personal credit. On this scale, each number is preceded by one of two letters: "I" signifies installment credit (like home or auto financing), and "R" stands for revolving credit (such as a credit card).
Each creditor will issue its own rating for individuals. For example, you may have an R1 rating with Visa (the highest level of credit rating), but you might simultaneously have an R5 from MasterCard if you've neglected to pay your MasterCard bill for many months. Although the "R" and "I" systems are still in use, the prevailing trend is to move away from this multiple rating scale toward the single digit FICO score. Nevertheless, here is how the scale breaks down:
|R0 or I0||You are new to the credit world, and you have an insufficient credit history for making an accurate judgment of your future risk.|
|R1 or I1||You pay your credit back in 1 month.|
|R2 or I2||You pay your credit back in 2 months.|
|R3 or I3||You pay your credit back in 3 months.|
|R4 or I4||You pay your credit back in 4 months.|
|R5 or I5||You have not repaid in four months, but you are not a "9" yet.|
|R7 or I7||Your debt payments are made under consolidation.|
|R8 or I8||Debt was cleared by selling the item (repossession).|
|R9 or I9||You officially have bad debt (default), which usually means it is uncollectible.|
What Makes Up Your Credit Score?
When you borrow money, your lender sends information to a credit bureau which details, in the form of a credit report, how well you handled your debt. From the information in the credit report, the bureau determines a credit score based on five major factors: 1) previous credit performance, 2) current level of indebtedness, 3) time credit has been in use, 4) types of credit available, and 5) pursuit of new credit.
Although all these factors are included in credit score calculations, they are not given equal weighting. Here is how the weighting breaks down:
As you can see by the pie graph, your credit rating is most affected by your historical propensity for paying off your debt. Although there are many ways you can improve your credit score, the factor that can boost your credit rating the most is having a past that shows you pay off your debts fairly quickly. Additionally, maintaining low levels of indebtedness (or not keeping huge balances on your credit cards or other lines of credit), having a long credit history, and refraining from constantly applying for additional credit will all help your credit score.
Although we would love to explain the exact formula for calculating the credit score, the Federal Trade Commission has a secretive approach to this formula.
Why Your Credit Rating Is Important
When you apply for a credit card, mortgage or even a phone hookup, your credit rating is checked. Credit reporting makes it possible for stores to accept checks, for banks to issue credit or debit cards and for corporations to manage their operations. Depending on your credit score, lenders will determine what risk you pose to them.
According to financial theory, increased credit risk means that a risk premium must be added to the price at which money is borrowed. Basically, if you have a poor credit score, lenders will not shun you (unless it is utterly awful); instead, they'll lend you money at a higher rate than the one paid by someone with a better credit score. The table below shows how individuals with varying credit scores will pay dramatically different interest rates on similar mortgage amounts - the difference in interest, in turn, has a large impact on the monthly payments (which pay off both interest and principal). As you can see, your credit score can affect your mortgage in many ways:
Credit Is a Fragile Thing
Being aware of your credit and your credit score is very important, especially since you can harm your credit without even being aware of it. Here's a true story of what can happen:
Paul applied for a travel reward miles card, but never received any response from the credit card company. Since it was a high-limit travel card, Paul just assumed that he'd been declined and never thought about it again. More than a year later, Paul goes to the bank to inquire about a mortgage. The people at the bank pull up Paul's credit report and find a bad debt from the credit card company. According to the credit report, the company tried to collect for a year but recently wrote it off as a bad debt, reporting it as an R9, the worst score you can get. Of course, all this is news to Paul.
Well, it turns out there was a clerical error, and Paul's apartment suite number was missing from the address the credit card company had on file. Paul had been approved for the card but never actually received it, and any subsequent correspondence didn't get through either.
So the credit card company still charged Paul the annual fee, which he didn't pay, because he didn't know the debt existed. The annual fee collected interest for a year until the credit card company wrote it off. In the end, after jumping though several fiery hoops, Paul was able to get the problem rectified, and the card company admitted fault and notified the credit-reporting agency.
The point is, even though it was a small balance due (about $150), the administration error almost got in the way of Paul getting a mortgage. Nowadays, since all data goes through computers, incorrect information can easily get onto your credit report.
Tips to Improve or Maintain a High Credit Score:
- Make loan payments on time and for the correct amount.
- Avoid overextending your credit. Unsolicited credit cards that arrive by mail may be tempting to use, but they won't help your credit score.
- Never ignore overdue bills. If you encounter any problems repaying your debt, call your creditor to make repayment arrangements. If you tell them you are having difficulty, they may be flexible.
- Be aware of what type of credit you have. Credit from financing companies can negatively affect your score.
- Keep your outstanding debt as low as you can. Continually extending your credit close to your limit is viewed poorly.
- Limit your number of credit applications. When your credit report is looked at, or "hit," it is viewed as a bad thing. Not all hits are viewed negatively (such as those for monitoring of accounts, or prescreens), but most are.
- Credit is not built overnight. It's better to provide creditors with a longer historical time frame to review: a longer history of good credit is favored over a shorter period of good history.
The Bottom Line
The importance of credit today is significant; overlooking this fact can be very detrimental to your financial health. Being aware of how your credit score is calculated is essential. By following the tips we have laid out for you, you should be able to either maintain or improve your credit score. Now that you understand the importance of your credit score, here are some of the major sites you can visit to check your credit rating:
Credit & LoansNot all plastic is equal! Learn the difference between the three kinds, and how each can affect your finances.
Investing BasicsIs the bond you're buying investment grade, or just junk? Find out how to check the score.
Credit & LoansThe average American household has four cards, but does that mean more is better?
Stock AnalysisLearn how receiving a greater than 7% yield from an oil major is a rare opportunity and one that comes with a fair share of potential dangers.
Credit & LoansUnderstand the difference between an average credit card and an elite credit card for the wealthy. Learn about the top five credit cards for the super rich.
BudgetingMoving in together is a big step. Here are some key financial questions to ask your partner before you make the move.
Credit & LoansIf you're getting a student loan, think critically about how you will manage your loan. Student debt could have a profound negative impact on your life.
Credit & LoansAn equated monthly installment is a fixed payment a borrower makes to a lender on the same date of each month.
Investing NewsA major office-supply company merger is now in the works between Office Depot and Staples. First attempted 18 years ago, will this time be the charm?
Credit & LoansCredit scores affect key aspects of your personal and professional life. Knowing your score and managing your credit input can make a big difference.
You have several options for reducing your debt burden. You can enroll in a professional debt management plan, or consider ... Read Full Answer >>
Filing bankruptcy is never a simple decision, but sometimes it is the best thing you can do in your current financial situation. ... Read Full Answer >>
The most impactful consumer protection laws and regulations in the United States are overseen by the Federal Trade Commission ... Read Full Answer >>
In general, the Social Security Administration, or SSA, does not encourage citizens to change their Social Security numbers, ... Read Full Answer >>
Depending on the need, an individual or business may take out a form of credit that is either open- or closed-ended. While ... Read Full Answer >>
Creditors that allow purchases to be made through financing often require property to be pledged against a credit account; ... Read Full Answer >>