In recent decades, consumers have become increasingly dependent on credit. When you use credit, you are borrowing money that you promise to pay back within a specified period of time. Having lenders extend you credit is a great privilege. If you have a good credit rating, enjoy it. Also, use credit responsibly. Credit is fragile; one slip up can create major problems; you can harm your credit rating without even being aware of it. Therefore, it's crucial that you understand your credit report.
Your Credit Rating Is a Critical Part of Your Life
Few things in life follow you as your credit report does. Your credit report and rating compose a financial snapshot that presents you to the business world. Your financial history can affect how easily you can get a mortgage, rent an apartment; make big-ticket purchases; take out loans, and in some industries even get hired. When you apply for a credit card or even a cable hookup, lenders check your credit rating. Your credit rating helps to determine the probability that you could and would pay back the money that you have borrowed; it also indicates the degree of risk that you pose to a lender.
Increased credit risk means that a risk premium must be added to the price at which you borrow money. If you have a poor credit rating, lenders may not shun you; but instead, they'll lend you money at a higher rate than that paid by someone with a better credit rating. The hypothetical data in the table below show how individuals with varying credit ratings can pay dramatically different interest rates on similar mortgages. The difference in interest, in turn, has a great impact on the monthly payments.
|How Credit Ratings Can Affect Mortgage Rates and Monthly Payments|
|Credit Rating||Mortgage Interest Rate||Monthly Payment|
What Comprises 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've handled your debt. This history appears in your credit reports of the three main U.S. credit bureaus, Equifax, Experian, and TransUnion. The credit bureaus also capture your credit history into a single number known as a credit rating or credit score. The bureaus base your credit rating on five major factors:
- Credit payment performance
- Current debt level
- Length of credit history
- Credit mix; types of credit available
- Frequency of applications for new credit
Although all these factors are included in credit score calculations, they are not given equal weighting. The table below cites the breakdown of the above factors by weighting. You'll see that, at a 35% weighting, the factor that is most important to your credit rating is to show a history of paying off your debts relatively quickly. Moreover, maintaining low levels of indebtedness; not keeping huge balances on your credit cards or other lines of credit (LOC); having a long credit history, and refraining from constantly applying for additional credit also will help your rating.
|The Five Major Factors That Bureaus Use to Determine Credit Rating|
|1) Credit payment performance||35%|
|2) Current debt level||30%|
|3) Length of credit history||15%|
|4) Credit mix||10%|
|5) Frequency of new credit applications||10%|
The FICO Rating
FICO is an acronym for the Fair Isaac Corporation, which created the statistical software used to calculate credit scores. Lenders use borrowers' FICO scores along with other details in their credit reports to assess credit risk and determine whether to extend credit. FICO Scores range between 350 (extremely high risk) and 850 (extremely low risk). Having a high score increases your odds of getting approved for a loan and helps with the conditions of the offer, such as the interest rate. Having a low FICO score can be a deal-breaker for many lenders.
As pictured in the graph below, in 2009, the average U.S. FICO score reached a bottom, at 686. In 2018, the average U.S. FICO score hit a new high of 704, showing a steady upward trend in U.S. credit quality.
The VantageScore Rating
The VantageScore system, developed in 2006, is weighted differently than FICO. In this method, lenders consider the average of a consumer's available credit, recent credit, payment history, credit utilization, depth of credit, and credit balances; with the biggest weight given to payment history and credit utilization. The VantageScore range ranges between 501 and 990. Those with a score of less than 630 are deemed to have poor credit. A score between 630 and 690 is considered fair, and 690 to 720 is considered good. A score of 720 and greater is excellent. Although an increasing number of creditors are using this system, it is not nearly as popular as FICO.
Why You Should Check Your Credit Report Regularly
Because your credit rating can have a huge impact on many of life's major decisions, you do not want it to contain errors or negative surprises. If you do find errors, you may correct them with the credit bureaus. If your report contains data that reflect you poorly, then you should be aware of the issues so you may explain them to potential lenders instead of being caught off guard.
Other parties view your credit report—generally with your permission—and so, of course, should you. By law, you are entitled to review the information in your credit report annually, and doing so does not affect your credit score. Each of the three U.S. credit bureaus—Equifax, Experian, and TransUnion—allows consumers one free credit report annually, via AnnualCreditReport.com.
Tips to Improve or Maintain Your Credit Rating
If your credit rating is good, then you want to improve or maintain it. If you have poor credit now, then rest assured that it's possible to improve it; you do not need to live with a particular credit score for the rest of your life. Credit bureaus allow information to fall off of your credit report in time. Typically, negative information falls off after seven years; but bankruptcies stay on your report for 10 years. Below are some actions you may take to improve or maintain your 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 affect your score negatively.
- 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 "hit"—that is, viewed—an excess number of requests for credit might be perceived negatively.