The definition of Credit Score is simple. It’s a measurement that gauges how reliable you are to pay back your debts, based on debts you’ve repaid in the past. It’s like a track record for your financial trustworthiness.
Once you get started building credit, you won’t have just one score; you’ll have four! This is because there are four credit bureaus that calculate a separate score for you based on their particular parameters of creditworthiness. Those companies are Equifax, Experian, Innovis, and TransUnion.
There is also what’s known as a FICO score, which accesses financial history from three of the credit bureaus: Equifax, Experian, and TransUnion. Since FICO scores are based on information from more than one bureau, they are the most widely used credit score out there. You can access your score by purchasing a report from www.myfico.com. Alternatively, some banks automatically provide a FICO score to you free of charge, which is usually updated once a month.
Why a Good Credit Score is Important
It’s vital to have decent credit if you want to succeed in financial aspects of your life. Here’s who will be checking your score, and why that’s important:
- Personal Loans. If you wish to purchase a car, pay for your education, or start a new business, you’re going to need a loan. Lenders are looking for someone who is responsible and able to pay their debts without issue. The larger the loan, the better your credit should be. In some cases you may be eligible for a loan with bad credit, but the interest rates will be higher to offset the risk of a defaulted loan.
- Applying for a rental. Good credit scores can seal the deal when looking for an apartment. Landlords need reliable tenants for at least 6-12 months. If you’ve financed and reliably paid for a previous purchase that was longer than a 12 month term, you should be in good shape.
- Employment screening. Employers won’t see your credit score directly, but they can (and should) access your credit history during the hiring process. This is a useful tool if the position involves handling money, like a bank teller or an armored truck guard. Spotted credit history could indicate a riskier employee, with concerns for theft or fraud.
How Credit Score is Calculated
Most people have a slightly different opinion on how credit is calculated. This is because the credit bureaus don’t reveal exactly how much our behavior influences each creditworthiness factor. Let’s take a look at what contributes to your FICO:
- Payment history, 35%. This will contain prior loans/financial obligations, and how well you did paying them off. If you missed a payment at any time within the last year, you can expect your score to be heavily impacted. If you’ve missed more than one payment, your score could be affected until you demonstrate good payment history for multiple years.
- Amount owed, 30%. Simply put, this is how much money you currently owe on other loans and obligations. If you were lent a large portion of money, your monthly payments could be disproportionately draining your monthly income. A lender might turn you down because it would be difficult to pay an additional loan payment on top of your current one.
- Length of credit history, 15%. The longer you’ve had good payment habits, the more reliable you appear.
- New credit, 10%. A more accurate name for this would be “average credit age”. If you have older credit that you repaid on time, it will always affect your score positively. However, when you open a new line of credit, it will impact your score negatively. All of your credit ages are averaged into one number, which is then reflected in the 10% towards your final score.
- “Credit mix”, 10%. Having different kinds of financial obligations will demonstrate that you’re versatile, and have no issues repaying debts of any kind. The more types of credit you’ve repaid, the higher this score will be.
Building Credit From Scratch
With all this information, it may be overwhelming to think about if you’ve never paid a debt. That’s okay, though, because we’ve got great ideas on safe and effective methods for you to get off on the right foot.
Secured Credit Cards
A secured credit card is an excellent option for someone without credit history, because they’re easy to be approved for. It works just like a standard credit card, however, you must place a deposit with your bank for the amount equal to your line of credit.
Let’s say for instance your bank offers you a $1,500 secured credit card. You’ll have to save and deposit $1,500 with the bank first before they’ll offer you the credit. If you fail to make payments on anything you purchased with credit, the bank will use your deposit to make the payment instead. In the worst case scenario, you could lose your entire deposit.
Retail Credit Cards
Retail credit cards aren’t the best offers around. They have high interest rates, and usually offer low credit limits. The good news is that you don’t have to pass a credit check before you’re approved for one!
One way to make use of these is to apply for one at a store you usually shop at, such as Target. Every month, make a few necessary purchases, then pay off your credit in full to avoid the nasty interest ratings. Contrary to popular belief, paying off all of your credit each month still builds credit history for you. Just more slowly.
College Credit Cards
These are the most akin to a standard credit card because they operate identically. You will be given a small line of credit, usually with a higher interest rating to account for the risk, and be expected to make payments on your purchases each month.
As you use the card for a few years, your credit history will mature and you will be eligible for better card offers from your bank, and larger lines of credit.
Become an Authorized User on an Existing Credit Account
You will need a parent or a partner with an existing credit card to pull this off. Once you’re added as an authorized user, their credit score will begin to impact yours as well. That’s great news if they have decent credit, and bad news if they don’t. Make sure you’re signing on with someone who’s financially responsible, or you could be shooting yourself in the foot.
Stick to One Card
It might be tempting to apply for multiple cards when you’re just starting since the credit limits are so low. We advise not to do this. Opening a new card will always decrease your credit score at first, and opening two cards within a short period makes you appear desperate for money. Do yourself a favor and stick to one card for a few years.
Credit Builder Loans
These are also known as “Fresh Start Loans” or “Starting Over Loans”. They’re specifically designed to help you build credit when you have none, or to help repair your credit if you’ve had poor payment reliability.
No credit is required to get started. When you “borrow” money with a credit builder loan, you won’t actually receive the money. It will be placed in a secure account that can’t be accessed until you pay back the loan.
A better way to think about it is like this: you are making a commitment to the bank that you will make on-time payments for the term of the loan, and in return, you will get all your money back. There is no financial gain from a CBL, but the benefit to your credit score could be invaluable.
You can’t get a loan with bad or no credit history, and if you don’t have a loan, you’ll have to pay for it the old fashioned way. Make it easier on yourself and find someone with a good credit score that’s willing to vouch for your financial abilities.
If you fail to make payments on a co-signed loan, your co-signer will still be on the hook for them. That can be a big responsibility, and not the best idea if you have inconsistent work/income.
Similar to being authorized on a credit card account, just without the card.
Try to start adopting good money habits that will positively impact your credit score. Here are a few strategies to keep in mind:
- Pay on time. This is the number one factor that affects your score. If you know you’re going to be late on payments, request extensions!
- Pay more than the minimum payment. Making the minimum payment insinuates that you can’t afford to pay more, and are likely in financial distress. Plus, the longer you’re paying your loan off, the longer you are accruing interest on your account. You’ll end up paying more money in the long run than if you had over-paid.
- Borrow responsibly. A given, but some folks can’t keep their card in their wallet. If you have a credit card, don’t max it out! Not only does it look bad on your credit report, but the interest percentages on credit cards can be punishing.
- Keep your accounts open. When you have more credit accounts open than you need, the amount of debt owed becomes a smaller percentage of your overall available credit. Let’s say you have $200 of debt on a $1,000 credit card. That $200 is equal to 20% of your overall credit for that card. Decent, but it could be better. Let’s say you also have an additional credit card with no debt owed, and a maximum of $1,000 credit available. When we calculate that $200 against the $1,000 of your first card and the $1,000 from your second card, that $200 would only be 10% of your overall available credit. To new lenders, this suggests that the amount of money you owe is relatively low when compared to how much credit you have been given.
- Check your scores when possible. You might think you’ve been doing everything right, but there’s always room to improve. Check your scores occasionally to see what changes you can make. It’s also a good way to prevent errors from impacting your score. Mistakes are rare, but if you see a sudden and significant drop on only one of your scores, you should inquire just to be safe.
Fixing a Low Credit Score
If you’ve read everything up to this point, you should have a good idea of what you need to be doing. Make payments on time, borrow responsibly, and be patient.
You may be inclined to settle your debts for a lesser amount, which might be the only choice in some cases. If you can avoid it, don’t settle your debts. It will greatly impact your score, and you could spend a decade making up for it.
Points on your credit history will remain for 7 years, while bankruptcies can remain for 7-10 years. You really want to be thinking ahead when making financial decisions, they could have major consequences when you’re not responsible.
Avoid Credit Repair Companies
In our experience, most credit repair offers turn out to be scams. There are companies that offer legitimate advice, or may settle debts on your behalf, but you must be vigilant when dealing with them. If they request money before providing services, it’s probably a scam. If they don’t provide clear documentation about services they will be providing, it’s probably a scam.
If you have a low credit score, you’re probably in financial distress. Don’t compound that problem by paying someone to fix what you already can on your own!
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Frequently Asked Questions
Whats the difference between a soft and a hard inquiry?
A soft inquiry is one that only you can see. If someone is performing a soft inquiry against your credit report, future inquiries by others will not show it. Hard inquiries are visible to anyone performing a soft or hard inquiry against your report, and are usually made when you apply for a credit card, loan, or mortgage.
I don’t want to pay for my credit report. What can I do?
Experian, Equifax, and TransUnion offer a free credit report once every twelve months. If you wish to review it again before twelve months, you will have to pay for them.
Does checking my credit history hurt my score?
No. Your score will only be affected when others make “hard inquiries” about your credit history.
How long do positive factors stay on my record?
Fortunately, positive factors stay on your record for 10 years, which is 3 years longer than negative factors (besides bankruptcy).