Your credit is the financial tool by which you are judged by any institution that is considering putting their trust in you financially. Whether you are applying for a credit card, a mortgage, an auto loan, or even a job; institutions check your credit in order to determine whether or not they want to do business with you.

Establishing credit and maintaining a good credit score are important to being able to succeed financially. Unless you have the cash on hand to be able to pay for everything you need in life, you are going to use your credit at some point to help you acquire something you either need or want.

The goal of this lesson is to teach you the most important things you need to know about your credit. This includes understanding what credit, a credit report, and credit score are, learning how to improve your credit score, and knowing what to take into consideration so you can make good decisions when it comes to your credit.

What is Credit?

When we talk about credit (as in “your credit”) we are generally talking about a person’s creditworthiness. In this sense, credit is a measure of trust, and creditworthiness is the financial equivalent of trustworthiness.

Credit is created when one party lends another party money with the expectation of being repaid at some point in the future. The lender puts his trust in the borrower, expecting that they will pay on time when the payments are due and pay all the payments until the money lent is fully repaid.

If the borrower keeps their promise and pays the lender completely and timely, then the borrower has good credit with that lender. If, however, the borrower is consistently late making payments or completely defaults on the debt, the lender will not lend money to them again and they would have bad credit with that lender.

As you probably already know, real life isn’t as black and white as our example, and that is why there is a credit reporting and scoring system in place, comprised of your credit report and credit score. This system is in place to help lenders or other organizations determine how much of a risk they are taking by lending you money or doing business with you.

Your Credit Report - Your Financial History

The first component of this system is your credit report. Companies that let you borrow money, and thus extend credit to you, report your history with them up to three major companies, called credit bureaus, and these companies keep a record of your credit history.

These three companies are Equifax, Experian, and TransUnion. Some companies report to all of these, but some companies only report to one or two. Because of this, your credit report at any of these could be significantly different from the others.

Companies that are thinking about lending you money or doing business with you can check your credit report with any of these credit bureaus in order to get a better idea of how much of a risk you are to deal with. All three companies assign you a credit score to gauge how creditworthy you are.

Because of the differences in the information the credit bureaus may have, there are models that compile all your information and calculate a single score for your credit, such as the FICO score.

Your FICO Score - The Mother of All Credit Scores

FICO is short for the Fair Issac Corporation, which is the company that developed the FICO score. The FICO score is the most used credit score in the world, and is primarily used in credit decisions made by banks and other institutions who lend money.

FICO scores range from 300 to 850, and they give lenders an idea of how likely you are to pay your bills on time and how likely you are not to default on your debts. If your FICO score is low, banks may not lend to you, may charge you a higher interest rate, may demand more collateral from you, or may require more extensive income and asset verification before deciding whether or not they should lend to you.

There are varying opinions about what a good FICO score is, but we recommend striving for a score of at least 720.

How a FICO Score is Calculated

The exact formula for calculating a FICO score is kept under a tight lid by Fair Issac, but here is approximately what is considered in the calculation of your FICO score.

Payment History (35%) - This is your past payment behavior. Late payments and defaults would affect this component.

Outstanding Debt (30%) - This is the amount of debt you carry compared to the amount of credit extended to you. Statistically, the higher the percentage, the more likely you are to default.

Length of Time You’ve Had Credit (15%) - The longer you’ve had credit, the more you show you can handle responsibility over a number of years.

Recent Activity and Inquiries (10%) - A surge in recent inquiries or opening of many new accounts sends the signal that you’re desperate for money and applying for credit at various places.

Types of Credit You Have (10%) - This proves that you can handle different types of debt such as revolving debt (credit cards), installment debt (car loan), mortgages, etc.

Improving Your FICO Score

There are several things you can do to improve your credit and FICO score. We’ve listed a few tips below that will make the biggest impact on your score.

1) Make sure you make all your payments and you make them on time. Over time, this will improve the heaviest weighted component of your FICO score. This will take time, but there is no substitute for paying on time.

2) For the Outstanding Debt component, you can do a few different things. The first, and best, of these options is to pay down your outstanding balances. If you have an account with us, your Finavigation Report will show you the most efficient way to do pay down all your debts.

The second thing you can do to improve this, is request a credit limit increase, as this will lower the percent as well. However, you must be careful that you don’t dip into this additional credit just because it is available to you.

The third option is to make sure your balances are spread out among different debts. For example, if you have one credit card that is maxed out and two other credit cards that you aren’t carrying a balance on, you could balance transfer some of the outstanding balance from the one card to the other two. Having 3 cards not maxed out is looked upon more favorably than having a single card that is maxed out.

The downsides with this third option are several, though. The two cards you transferred the balances to may have higher interest rates, you may be hit with balance transfer fees, and you would have 3 payments to remember to make a opposed to one. Because of this, we wouldn’t recommend doing this. There are just too many downsides.

We would prefer that you gradually pay down your balances, and if you want to request a credit limit increase while you’re doing this, that would be a winning strategy in our opinion.

3) When you pay off a credit card, do not close the account. If you close the account, you are decreasing the amount of credit extended to you, which will hurt your credit score - especially if the account you’re closing is one that you’ve had for several years. If you think you’re going to be tempted to overspend with the credit card, cut it up but don’t close the account.

4) Check your credit report once a year for errors. You can obtain a free copy of your credit report every year from AnnualCreditReport.com. It is not uncommon for credit reports to have errors on them that negatively impact your FICO score.

Now that you know about credit, and how to improve yours, you can get started putting some of these strategies in place to get your FICO score up and get yourself on your way to a better financial situation.

This lesson has been featured in:
NIL2MILLION: Everything About Personal Finance 11th Edition

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