(Re)Building CreditIf you want to buy a home, a car, get a job, rent an apartment, get insurance, etc. you need to understand the importance of your credit and credit history. Whether you’re building or rebuilding your credit, start with a basic understanding of credit reports and credit scores.
Credit Reports and Credit Scores
When it comes to building or rebuilding credit, understanding what’s on your credit report and what’s included in your credit score is important.
What’s a Credit Report?
You can think of your credit report like a financial report card. It displays your financial history, specifically focusing on your borrowing history. It includes:
- Basic information about you, such as current and former addresses
- Current loans/accounts and history
- Credit inquiries (when you apply for new credit or when others request your information)
- Bankruptcies or collections.
What’s a Credit Score?
If your credit report is like your financial report card, your credit score is like your financial GPA. It takes information from your credit report and calculates a score that lenders then use to determine whether they want to lend you money, and if so, the interest rate and terms.
Different Reports and Scores
Many people assume they only have one credit report and one credit score. In reality, you have multiple credit reports and multiple credit scores.
Fair Isaacs Corporation developed the most popular and well-known credit scoring model, the FICO score. Your FICO score is based on the data on your credit report.
There are three credit reporting bureaus – Transunion, Equifax, and Experian – and each of them have a credit report for you. The data on each of these credit reports could be different for a variety of reasons including when a lender submits information or to which bureau they send it.
Each of the credit reporting bureaus have their own credit scoring models that are similar to FICO, but use their own formulas.
Despite the number of reports and scores and the differences between them, in general, you want to remember that higher scores are better. Each lender determines which score correlates with which rate, but higher scores correlate with lower rates for borrowing.
Five Main Factors
While there are a number of different credit scoring models out there that each use their own formula, there are five main factors that are considered when calculating credit scores.
The percentages and information used here are based on the FICO scoring model, but are similar for other credit scoring models.
Payment history is the largest factor in calculating a credit score.
- How late was your payment?
- How recently did it occur?
- How many late payments do you have?
- How much did you owe?
When evaluating payment history, the more severe, recent, and frequent the late payment, the greater the impact will be on your score.
An easy thing to remember: always make your payments on time and one-third of your score will be perfect.
Amount owed looks at a few things:
- How much money you owe to lenders across all accounts
- Amount owed on specific types of accounts
- Number of accounts with a balance
- Credit utilization ratio on revolving accounts
- Remaining amount owed on installment loans
Your credit utilization ratio looks at how much you have borrowed on revolving debt (such as credit cards) compared to the amount available to you.
For example, if you have a $10,000 limit on your credit cards and you have borrowed $9,999, your credit utilization ratio would be 99.9%.
Ideally you want to keep your credit utilization ratio as low as possible – below 30% is usually the recommendation.
Length of Credit History
Lenders and credit scoring models look at past behavior as an indicator of future behavior. When evaluating credit history, they are looking at three main things:
- Age of oldest account
- Average account age
- Age of specific types of accounts
If you are new to credit, you will need at least six months of reported account activity and history before you will have a FICO score.
New credit looks at how often you are going out and applying for credit. It looks at:
- Number of new accounts
- Date you last opened a new account
- Recent requests for credit
If you are applying for multiple loans to get the best rate (rate shopping), FICO and other credit scoring models will consider that one inquiry if these applications/requests for credit fall within a certain window – typically 14 days.
Types of Credit
The last factor, types of credit, looks at the different types of loans and accounts you have. Ideally, you’d have an installment loan or two (say for a vehicle), maybe one or two revolving accounts (such as a credit card), and maybe a mortgage.
Remember, not all credit is created equal. When looking at types of credit, a mortgage loan is typically “better” than a retail card from your favorite store or a payday loan.
This factor is more important when you don’t have a long credit history.
Credit Errors and How to Fix Them
Errors on your credit report are more common than you might think. According to a 2012 Federal Trade Commission study, about 1 in 5 Americans have an error on their credit report.
Credit report errors can negatively impact your credit score and, depending on the type and severity of the error, can prevent you from getting credit.
Three Main Types of Errors
Account related error
- Late payment listed that’s more than seven years old
- Credit card or loan account listed doesn’t belong to you
Account closed by you, but shown as closed by the provider
Account related errors could keep you from getting credit and could be a sign of fraud.
Derogatory mark error
- Paid-off collection item showing as unpaid
- Paid tax lien more than seven years past date of payment still listed
- Account discharged in bankruptcy still showing as active with a balance
Derogatory mark errors could keep you from getting credit and could be a sign of fraud.
Personal information error
- Wrong name listed or misspelled
- Address listed that you’ve never lived at
- Inaccurate employer information
Personal information errors could be a sign of fraud.
According to the Fair Credit Reporting Act, you have the right to know what is in your credit file, dispute incomplete or inaccurate information, and limit “prescreened” offers of credit and insurance.
Consumer reporting agencies have to correct or delete inaccurate, incomplete, or unverifiable information and may not report outdated negative information.
Get your credit report.
To fix errors on your credit reports, you first need to get your credit report. You have the right to access your credit report for free annually from each of the three reporting bureaus. The government sponsored site to do so is annualcreditreport.com.
Go over it carefully.
When you get your report, review it carefully for any possible errors. If you find any errors or information you don’t recognize, highlight or circle it.
File disputes for each claim.
If you find errors on your report, you need to file a dispute for each claim. You can do so online or via mail. If you decide to do it online, you can visit the Credit Reporting Bureaus website and should easily be able to locate how to file a dispute. If you decide to mail your dispute, you can also find example letters online. Either way, you’ll want to detail the issue and provide supporting documents.
Four Things to Know About Credit
In addition to knowing more about credit reports and credit scores, these four tips can help you better understand and know how to build and improve your credit.
Your credit helps determine if you get a loan and how much you will pay in interest.
Lenders use credit reports and scores to determine the cost of borrowing, also known as your interest rate.
With a higher credit score, you’re more likely to pay back what you borrow on time, so your cost of borrowing is lower.
With a lower credit score, you are a higher risk of not paying back what you borrow on time, so your cost of borrowing is higher.
|Low Credit Score||High Credit Score|
|Payoff Time||14.8 years||11.7 years|
Your credit report and score aren’t the only things that matter when a lending decision is made. Other things considered include:
- Stability: how long have you worked where you are? How long have you lived where you live?
- Comparable debt: have you borrowed this much before? Can you handle this debt?
- Escalating debt: would you be taking on too much debt too soon?
- Relationship: how long have you been a member? What history do you have with us?
- Capacity ratios: debt-to-income, payment-to-income, revolving debt, disposable income
- Collateral: can the property or asset be used to secure the loan?
You need to use credit to build credit.
To build or rebuild credit, you need to use credit. You need to show that you can responsibly handle credit that is given to you.
Things to remember:
- Don’t borrow just to borrow. Have a reason for borrowing money.
- Make your payments on time. This will help build your credit history.
- If using revolving credit such as a credit card, pay off your balance in full every month. Just because you have to use credit doesn’t mean you have to carry a balance.
- Limit the number of open accounts. Try to keep it to 1-2 credit cards from your financial institution (not retail stores), an auto loan, and maybe a mortgage.
This does not mean…
- You have to carry a balance on your credit cards.
- You have to be in debt.
- You are rewarded for having debt.
The better your score, the harder you fall.
When making lending decisions, typically those borrowers with a higher credit score are considered a low risk and will have a lower interest rate. These borrowers have shown a pattern of positive credit behavior – they’ve consistently made on time payments, keep their balances low, have a longer credit history, don’t open new credit often, and have a good mix of credit.
So if someone with this type of behavior suddenly makes a late payment, it’s highly unusual. As a result, their credit score will take a bigger hit.
For example, Bert has a 780 credit score and no late payments. Ernie has a 680 credit score and a 90-day delinquency from two years ago and a 30-day delinquency from one year ago. They each make a 30-day late payment that is reported to the credit bureaus. While Bert’s score could drop 90-110 points, Ernie’s may only drop 60-80 points.
Negative information eventually “ages” off.
There are time limits on how long negative information can be reported and remain on your credit reports.
If you have any negative information on your account, remember the older the negative item, the less impact it will have on your score.
|Type of information||How long it will remain on credit report|
|Late Payments||7 years|
|Completed Chapter 13 Bankruptcy||7 years|
|Chapter 7 Bankruptcy||10 years|
|Collections||7 years, but depends on the age of the debt being collected|