What is credit and why do you need it?

America became the largest economy in the world because of a concept called credit. Christopher Columbus was able to discover the new world (Bahamas) because of credit from the Spanish government and private Italian investors. The concept of credit can be explained when one person receives money, goods and/or services from another person without having to pay for them immediately and/or instead payment is due at a later agreed upon date.

American consumers need credit to make large purchases for houses, cars and emergencies. Since 70% of Americans live paycheck to paycheck, credit is essential to our daily lives. In 2007, total American consumer debts were about $2.5 trillion, where credit card debt accounted for 36 percent of the total. On average, consumers carry about $10,000 in credit card debt. Entrepreneurs also rely on credit to start businesses that provide us with goods and services, which allows our economy to grow and increase our overall standard of living.

The person who loans the money, goods and/or services is called the creditor or lender and the person who receives those items is the debtor or borrower. Credit is more than just a plastic card you use to buy things-it is your financial reputation in the business world. Good credit means that your history of payments, employment and salary make you attractive (less risky) for a loan, and creditors-those who lend money or services-will be more willing to work with you.

Having good credit means you pay less interest (the cost of borrowing money) and lower monthly payments, and you have less difficulty borrowing money for your purchases. Bad credit, however, can be a big problem. It usually results from making payments late or borrowing too much money, and it could result in you having trouble getting a car loan, car insurance, a credit card, a place to live, business startup capital and sometimes, a job!

What is a credit score?

One of the most important numbers in your personal and financial life is a three-digit number ranging from 300-850 called F.I.C.O. or simply, your credit score. F.I.C.O. actually stands for Fair Issac Corporation and was founded in 1956 by engineer Bill Fair and mathematician Earl Isaac. These two created the confidential formula and sold it to the three major credit-reporting agencies (CRAs) Experian, Equifax and TransUnion, who use the information in your credit report, along with FICO formula to compute your score. Generally, people with scores below 620 are considered poor risks, and those with scores above 680 are considered acceptable risks. According to F.I.C.O., the typical score in America is a FICO of 723.

Credit Reporting Agencies (CRAs)

The three major CRAs mentioned above have established relationships with businesses, banks, credit-card companies, utilities, mortgage companies, and other institutions that lend you money or provide you with goods and services on credit. They then collect information about you from those businesses regarding the transactions you make that involve credit. Most businesses report credit information about you monthly or quarterly to the CRAs, who finally produce your personal credit report and compute your credit score.

For example, let’s say you apply for a credit card and provide the card company with all of your personal information, such as your name and address, your previous address (if you haven’t lived at your current residence for more than two years), your employer, other credit cards you have, etc. The credit card company then contacts a CRA and reviews your credit report.

If the company approves your application for a credit card, then the information you’ve supplied is forwarded to the CRA. That credit card company also reports your payment history to the CRA, so that becomes part of your report. The CRAs will also access information about you from public records information such as bankruptcies, tax liens, lawsuits, foreclosures, judgments, and wage attachments. Most large creditors like Bank of America report to all three major CRAs, however smaller creditors may only report to one. This is why it’s important to review your report from all three CRAs because they may not have all the same information about you.

What determines your FICO score?

35 percent of your score is based on your payment history, which makes sense since one of the primary reasons a lender wants to see the score is to find out if you pay your bills on time. Your score is also affected by how many of your bills have not been paid on time, how many were sent out for collection, bankruptcies, and repossessions. The more recent your delinquencies have occurred, the lower your overall score.

Helpful tips: Pay all of your bills on time, if you’ve missed payments get current immediately because the longer you pay your bills on time the better your score. Understand that paying off a collection will not remove it from your credit report; it will stay on your report for seven years or more. You can also challenge incorrect items on your report and the CRAs have 30 days to respond or they must remove the item from your report.30 percent of your score is based on the amount of debt you have accumulated compared to the amount of available credit for you or what is simply called your debt ratio. Also included is how much you owe on car and home loans, how many credit cards you have that have reached their limit and the number of accounts you have with outstanding balances.

Helpful tips: The more credit cards you have at their limits, the lower your score will be. You should keep your debt ratio (total debt / available credit) at 35% or less of your credit limits ($1,000 card should have no more than $350 balance). A good way to do this is to spread the debt over three to five cards. For example, Tonya has $5,000 in total debt and two credit cards. The first card has a limit of $5,000 and the second card has a limit of $10,000. To maximize her credit in this situation she should leave $1650 on the first card (33% debt ratio) and transfer $3350 to the second card (33.5% debt ratio).

15 percent of your score is based on how long you’ve had credit. The longer you’ve had good credit, the higher your overall score. Why? Because there will be more information about your payment history and this gives creditors a better prediction of your future actions. Also included is how long you’ve had open accounts and the time since financial activity on those accounts.

Helpful tips: Try not to close any accounts especially older accounts that show you’ve had good payment history. If your interest rates are low, take your time paying off those student loans and build some good payment history. If you have not had credit very long don’t open a lot of new accounts in a hurry. New accounts will lower your average account age, which will have a larger effect on your score if you don’t have a lot of other credit history.

10 percent of your score is based on the number of inquiries on your report. If you’ve applied for numerous credit cards or loans, you will have many inquiries on your credit report. Generally, these are bad for your score because they mean you may be in some kind of financial trouble or your accumulating large amounts of debt. The more recent these inquiries are, the lower your overall credit score. If the inquiries are older than a year they won’t be counted in your FICO score.

Helpful tips: Whenever you’re shopping for the best mortgage and auto loans, make sure you apply for these loans within a 30 day time period. By doing this your score will not be affected by “multiple inquiries” and will count only as a single inquiry on your credit report. Also, when you personally request your credit report it will not affect your score as long you order it directly from a CRA.