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Credit

You have probably heard people talk about credit scores, or "building credit." Most people begin to establish credit in college or early adulthood, when you might first have a student loan, credit card, apartment lease, or cell phone bill.

Credit reports & credit score

All of your credit accounts are reported to Credit Reporting Agencies (CRAs), which gather information about your finances, including credit accounts, payment history, where you live and work, and other information. There are three credit reporting agencies in the United States:  Equifax, Experian and TransUnion. These agencies are not operated by the government.

Your financial information is collected into a credit report, which outlines your complete credit history.  Your credit report may be accompanied by your credit score, which is a snapshot of your financial history calculated into a three-digit numerical score, also frequently referred to as your FICO score. FICO scores range from 300 to 850, and a good credit score is typically considered to be 720 or higher.

Your credit report and credit score are the primary factors in your ability to borrow; they outline to potential lenders your level of responsibility (or risk) as a borrower. In other words, your past financial habits determine your ability to obtain credit in the future, as well as the interest rate you will have to pay on future loans. Responsible borrowers are generally able to open new credit accounts more easily and pay lower interest rates; irresponsible borrowers may have a harder time qualifying for new credit and generally must pay higher interest rates.

Some forms of credit are easy to establish, such as student loans and low-balance credit cards. Larger or more complicated forms of credit, such as mortgages, have more extensive requirements. Typically, you must demonstrate that you are a responsible borrower with smaller forms of credit before you will qualify for more significant forms of credit.

Per federal regulations, you can obtain a free copy of your credit report from each agency once every 12 months, available at www.annualcreditreport.com. You should review your credit reports annually to check for errors. While the report is free, you usually have to pay a fee (around $8-$15) to obtain your official calculated credit score. Some banks and credit cards will offer estimated scores using a similar formula for free.

Credit factors

What do the credit agencies do with your account information?  What are lenders looking for in potential borrowers?  How is your credit score calculated?  Your credit score is calculated based on the factors outlined below, which have varying impacts on your overall score.

Payment history

The amount and timeliness of your monthly payments for all accounts is reported to the credit agencies and appears on your credit report. This factor is among the most important in determining your credit score:  Consistent on-time payments demonstrate responsible borrowing, while even just a few late payments can really hurt your credit. Your credit report will also include any derogatory marks for accounts that have been reported delinquent, been referred to a collection agency (also known as "gone into collections"), or resulted in legal action (for example, if you are sued).  Derogatory marks can have a correspondingly severe impact on your credit for several years into the future.

Credit card utilization

It is generally recommended to keep your total credit card utilization under 30%. This means that if you have two credit cards with limits of $1,000 each, you should try to have a maximum total balance of $600 between the cards at any given time.  Lower is even better.

Age of credit history

This includes the average length of time your credit accounts have been open, as well as the last activity or payment on each account. If you open a credit card in college, it may help boost your credit score if you keep it open and in good standing in the future, since it lengthens your overall credit history.

Number and types of accounts

A high number of total accounts, accompanied by good payment history and account utilization, indicates to a lender that you are responsible and have trustworthy credit.  The number of total accounts has a lower impact on your credit than your payment history, but this is another important factor that creates your credit score. Diversity of account types (e.g., credit cards, installment loans, mortgages, etc.) is also a factor; larger or more complex loans, such as real estate loans, can have a strong positive impact on your credit if properly managed.

Credit inquiries

Each time you submit a credit application to a lender (e.g., you apply to your bank for a credit card), the lender will run a credit check to review your credit report and score. This is called a "credit inquiry," or a "hard credit inquiry."  This is a fairly low-impact category, but if you apply for many new accounts at the same time, this can indicate risk to lenders; if you borrow too much money at one time, you are less likely to be able to pay it back.

Credit resources

While many other services charge a monthly fee to view and monitor your credit, Credit Karma offers their service for free. In exchange, there are quite a few advertisements included in their services, so be cautious when reviewing financial advice or recommendations on its site.

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