Have you ever had a friend that wanted to borrow $20 and you had to determine if he or she would pay you back before you gave them the money? That is the same thing lenders go through before lending money. Their process is a little more involved, but ultimately it comes down to understanding whether a person can reasonably repay the debt. Simply put, credit is your official financial trustworthiness.
How do creditors make that determination? For you, it was a little easier; you knew your friend, and therefore, knew fairly well whether they would keep their word or not. With lenders, it's a little different because they don't know you. They have to rely on your credit history and repayment information to make that determination. They use tools such as a credit report and credit score to determine your creditworthiness, and what interest rate they will offer if they approve the loan.
There are three credit bureaus - Experian, Trans Union, and Equifax. These credit bureaus collect data from creditors and generate a report that includes this information in one collective place. This provides other creditors the opportunity to evaluate your credibility. Anytime you rent an apartment, buy a house, apply for a credit card or loan, or make a payment to a loan, this history is reported to the credit bureaus. Directly in line with this report is the credit score. The credit score is a numerical interpretation of the entire credit report. The scores range from 300 to 850 and the higher the score, the more creditworthy you become.
How exactly does credit work? The credit bureau assigns a point value to certain credit activities. These points can be either added or subtracted from your credit score, depending on what you are doing. It is important to understand that inquiries and credit applications lower your credit score. Other lenders look at the amount of inquires and applications that have been made in the last 12 months. That inquiry can tell the lender a lot about a person's creditworthiness, and some individuals have been denied credit because of excessive inquiries. In addition, submitting applications also takes away from your credit score. This is what is commonly referred to as a "hard hit" against your credit. This means that points were subtracted. A "soft hit" means only certain information was viewed and the entire report was not accessed, so no points were subtracted. An example of a "soft hit" is the pre-approval offers that arrive in the mail.
Credit scores can be a catch-22. For example, the average consumer has seven credit cards. If an individual has all seven of those cards maxed and is requesting more credit, then that is a concern for lenders as this reflects an inability to keep up with the current debt they have. On the other hand, if the consumer has seven credit cards and carries no balances whatsoever, that can be a bad sign, as well. While it is important to keep balances available on credit cards, having too much can actually hurt you.
A person's history stays on the credit report for seven years; however, any derogatory information on the report only affects the credit score for five years. Creditors still look at that history in its entirety and will make decisions based on the overall picture. Most lenders find the break even score to be about 620. This means that they will lend to you with scores in the 620 range, however, you are considered a higher risk and will receive a higher rate of interest. If you are below 620, finding an unsecured loan is a little more difficult.
Here are some tips to help keep your credit in good standing:
- ALWAYS pay your bills on time - many people would be surprised to know how this significantly impacts your credit score.
- Keep inquiries to a minimum.
- When closing credit accounts, do not close your oldest credit account. This closes out all of that history and affects your score because the rest of your credit is newer credit. Lenders like long-term financial stability!
- Do not have your credit cards maxed or sitting with zero balances. The point is to show that you can repay your debt every month without over-extending yourself, and that you have emergency funds available.
- Be careful of cosigning loans or putting things in your name unless you are 100% sure that the other person will pay as agreed. Any responsibility you take for something will reflect negatively on you if the loan defaults.
- Know your rights! You are entitled to a free credit report every year from each of the three bureaus. Take advantage of that and monitor your credit to be sure that everything is correct. If it isn't correct, dispute it and get the issues resolved.
Credit is one of the most important financial tools in today's society. Just being conscientious of your credit activities and applying discipline to your finances is the best way to help improve your creditworthiness. If in doubt, you can always talk to someone about your credit report. Most banks offer their clients a free credit review service to explain each point in detail and can help make a plan to improve your credit and score. The credit review is important to start early as it will make the bigger purchases, such as a mortgage, much easier and a lot less expensive!