In this article, you will learn everything you need to know in order to build credit.
I’ve shared my bankruptcy, the recovery, and how to easily build credit. I wanted to end this series with a monster post on all things credit. I channeled my inner nerd and basically wrote a term paper that outlines everything I could think of regarding this topic.
Everything included in this article is stuff I wish I knew when I started my credit journey. It really sucks to learn all of these important lessons after you’ve made terrible financial decisions, but it’s better to learn it later than to never learn it at all.
If you haven’t learned these important points regarding credit, I’m glad you’ve found your way here. If you already know all this stuff (fist bumps, yo) do me a favor, pass it along to someone who may need it! Without further delay, let’s drop some knowledge about credit.
What is a credit score?
A credit score is a numerical summary of a person’s credit risk. Essentially, it’s a compilation of information provided by the three major credit agencies — Experian, TransUnion, and Equifax.
This number helps potential lenders evaluate the risk of lending money or credit to a consumer. It also helps lenders determine the amount of credit to extend to a consumer along with terms and interest rates.
The most common number is the FICO credit score which was created by the Fair Issac Corporation. The score is reported by all three credit agencies named previously. Individuals with a high FICO score receive the best credit offers.
To get an idea of what category your credit score falls within, see below.
|
Excellent |
750 and up |
| Good | 700 to 749 |
| Fair | 650 to 699 |
| Poor |
600 to 649 |
| Bad |
anything below 600 |
How can someone build their credit score?
If you’re new to credit, you may find it difficult to secure a credit card that provides a good interest rate.
Competitive interest rates are usually reserved for those with a history of paying their bills on time and maintaining a decent credit utilization score.
It’s wise to only apply for credit when you need it or trying to build your history. Avoid opening cards for in-store discounts or simply for other promotional opportunities presented while shopping.
So what do you do if you’ve been turned down for credit?
In addition to factors such as job history, you may be rejected for major credit cards if you have never had credit.
If you’ve been turned down for credit, try to build your credit using a secured credit card. A secured card is basically where you extend yourself credit.
You place a certain amount of money (think of it as a security deposit) on a card and it is used as collateral against purchases you make.
Your credit limit is based on your income, your ability to pay the amount back each month, and the amount of the initial deposit to the card.
Let’s say you have $700. You would put $700 on the card as a security deposit. Each time you use your secured credit card, you can charge no more than the amount that is available on the card.
If you charge the entire amount, you will either pay the entire amount off or your creditor may allow you to add another deposit to extend the credit.
These types of cards are ideal for individuals who have a bad credit history and need to rebuild or for those who are just starting out building credit.
The secured card helps you build credit because it is reported to the three credit agencies each time you make the monthly payment.
After approximately a year of use, an unsecured credit card may become a viable option if you’ve used your secured card wisely.
Tip: Make sure to keep the balance on your secured credit card low relative to the credit limit (amount of security deposit), known as a credit utilization ratio. This, in addition to on-time payments, will improve your credit score.
What is a utilization ratio?
A utilization ratio is the ratio of the total amount of credit being used in relation to the total amount of credit extended to you.
A high utilization ratio can negatively impact your score because you are using a lot of the credit available to you.
A low utilization ratio is favorable because it means the total debts owed are small in relation to the amount of credit you have.
People with a high utilization ratio are viewed as a risk because they are more likely to default on their loans.
When you default on your loans this simply means you are borrowing more money than you can afford to pay back each month (or either being completely negligent).
Also if you have several credit cards and decide to close an old one you are no longer using, you are eliminating some of your available credit which can increase your utilization ratio.
Let’s take a look at an example to see how this works:
Pretend you have four credit cards. Two major cards and two department store cards.
- Major Card 1: $100 balance and a $1,000 limit
- Major Card 2: $500 balance and a $2,000 limit
- Department Store Card 1: $0 balance and a $1500 limit
- Department Store Card 2: $15 and a $300 limit
This is what your credit utilization ratio would be given the scenario:
Total Balances of Credit Used: $615
Total Credit Available: $4,800
Utilization Ratio: .128 or 13% (Divide credit used by credit available)
Given this example, your credit utilization ratio would be low and positively impact your credit score.
However, if you decide to close one of the department store cards without a balance because you never use it, let’s see what happens:
- Major Card: $100 balance and a $1,000 limit
- Major Card: $500 balance and a $2,000 limit
- Department Store Card 2: $15 and a $300 limit
This is what your credit utilization ratio would be given this scenario:
Total Balances of Credit Used: $615
Total Credit Available: $3,300
Utilization Ratio: .186 or 19%
While this credit utilization score isn’t high, you can see that closing an account makes your credit utilization go up.
Let’s see what happens if you don’t pay the $500 balance off in full and charge another $300 to it:
- Major Card: $100 balance and a $1,000 limit
- Major Card: $800 balance and a $2,000 limit
- Department Store Card 2: $15 and a $300 limit
Your credit utilization score after additional purchases and closing an account would be:
Total Balances of Credit Used: $915
Total Credit Available: $3,300
Utilization Ratio: .277 or 27%
As you can see, your utilization score will continue to take a hit month after month if you only make the minimum payments and not pay off the card in full each month. It’s ideal (highly recommended) to keep your credit utilization score below 30% across ALL of your credit cards.
Some scoring models penalize you for using more than 30% on one card.
Unfortunately, the only way to stay one step ahead with regards to your utilization ratio is to keep your balances low.
If you’re approaching 30 percent utilization on one or more of all your credit cards, make multiple large payments on these cards per month or ask for a credit increase.
As someone who has been in a depressing amount of consumer debt, I’d recommend paying more than the minimum or not charging up a high balance at all!
How do I check my credit score?
Some credit companies offer free score monitoring. If you already have a card, check their online website or call the customer service number on the back of your card to determine whether this free service is offered.
If not, you have the option to sign up for monthly monitoring of your score.
The most common score is FICO (reported by the three major credit agencies); however, you could also monitor your score using VantageScore.
You should read about the differences between FICO and VantageScore and keep up with one score.
What is a credit report?
Your credit report is a detailed history of a person’s credit history as reported by three credit agencies (Equifax, TransUnion, and Experian).
This report gives lenders an idea of a person’s creditworthiness and contains personal information such as previous addresses and employer history.
The information in this report determines your score.
How can I check my credit report?
Each year you can check your report using the only government sanctioned website that provides this information. All information is provided by the three major reporting credit agencies.
This website is called Annual Credit Report. You can use this free report to check for errors and dispute anything that appears to be incorrect in your credit file.
You also need to verify each account listed on your report has the correct name and address associated with it.
How do I responsibly build credit?
Check out this article How To Easily Build Credit for all the deets I spill on responsibly building credit.
What if I’m married? Do spouses have joint scores?
Married couples do not have a combined score. Every individual has their own score.
If a married couple applies for a joint loan, mortgage, or card — the financial behaviors of each person could affect each individual’s score.
If a credit card is in both spouses name and it isn’t paid on time, both scores would be negatively affected.
What affects my score?
The following can negatively affect your score (this is not an all-inclusive list):
- Inquiries
- Late Payments and History of Payments
- Foreclosures
- Judgments
- Repossessions
- Collections
- Bankruptcy
Credit Inquiries
Inquiries are requests made by businesses when they check your credit. Types of businesses that check your credit include insurance companies, cellular phone companies, potential employers, automotive companies, banks, landlords, etc.
Each inquiry is classified as either a hard or soft inquiry. Soft inquiries are made by you, employers, or credit checks from businesses with whom you already have credit.
Hard inquiries affect your score. These inquiries are made by business for which you may have applied for mortgage loans, auto loans, or credit cards.
Hard inquiries are viewed individually unless you are rate shopping. Rate shopping is a period where you are searching for the best rates for auto, student, or mortgage type loans. FICO considers any type of inquiries during these time periods to be a single inquiry because you are shopping for a rate.
FICO considers any type of inquiries during these time periods to be a single inquiry because you are shopping for a rate.
Inquiries have a minor effect; however, for some individuals, an inquiry could take off up to 5 points. If an individual doesn’t have that many accounts or very little credit history, a hard inquiry could have a large impact on their score. Creditors view numerous inquiries on a person’s report as a risk. You can minimize the number of hard inquiries on your report by only opening lines of credit when truly needed.
Creditors view numerous inquiries on a person’s report as a risk. You can minimize the number of hard inquiries on your report by only opening lines of credit when truly needed.
Late Payments
Late payments are viewed in terms of how frequently payments are made late, how severe they are, and how recent. This basically means a late payment as recent as 30 days ago has a greater damaging impact to your score than a late payment that happened sometime last year.
Creditors report late payments in the following categories: 30 days late, 60 days late, 90 days late, 120 days late, and write-offs (severe delinquency in payment). If a payment is about to be written off, this is serious and has a greater impact than any other late categories previously mentioned. It’s easier to recover from a late payment prior to a write off if you get current on the account.
If a payment is about to be written off, this is serious and has a greater impact than any other late categories previously mentioned. It’s easier to recover from a late payment prior to a write off if you get current on the account.
Staying current on accounts is the best way to build a solid payment history. A solid payment history has a positive effect on your score. If you think you will be late with a payment, it’s best to work with the lender beforehand to see if there is anything they can do to help you.
If your creditor isn’t willing to work with you, try avoiding delinquency at all costs as a severe delinquency could result in a write-off. Once this happens, you won’t be able to get current on that account. This is why it’s best to be proactive in the event you can’t pay on time!
Once this happens, you won’t be able to get current on that account. This is why it’s best to be proactive in the event you can’t pay on time!
Late payments and write-offs can remain on your report for 7 years.
Foreclosure
A foreclosure occurs when a bank or lender takes possession of a mortgaged property. This happens when individuals are seriously delinquent on their home loan payments. A common alternative to a foreclosure is a short-sale. Both events carry the same weight when it comes to your FICO score.
A common alternative to a foreclosure is a short-sale. Both events carry the same weight when it comes to your FICO score.
Foreclosures stay on your report for 7 years.
Judgments
If you are seriously behind on your payments, the company can file a lawsuit with the courts. A judgment essentially gives a creditor the ability to seek additional methods to collect the debt that is owed to them.
You could settle before a judgment is issued; however, if one is issued and found in favor of the creditor, you could experience a garnishment of wages and/or liens against your personal property and real estate.
Once a judgment is issued by the court it becomes public record and has a huge impact on your credit score.
Judgments stay on your report for 7 years.
Collections
Collections occur when a person is delinquent on their credit and/or medical accounts. After passing through the late payment categories as discussed previously, an account can be sent to collections.
Collections typically occur after 180 days past due. If you have a high score, your score will take a significant hit. You have more credit to “lose”, so to speak than someone with a lower score.
Collections stay on your report generally for 7 years (depends on the age of the debt being collected).
Bankruptcy
The impact of bankruptcy depends on each individual’s credit profile. Someone who has a good credit score and a flawless record could take a MAJOR hit if they filed bankruptcy.
Their score would drop substantially. An individual with many negatives on their report and a lower score may only receive a slight decrease in their credit score in the event of bankruptcy.
The two most common types of bankruptcy filings are:
- Chapter 7 is where some property is liquidated to pay back of a portion of debt. Some property may be kept that is exempt under state laws. Chapter 7 stays on your report for 10 years.
- Chapter 13 is the most common and is when you can keep all of your property, but you must make payments over the course of 3 to 5 years to pay back a portion or all of your debt. Chapter 13 stays on your report for 7 years.
What if I’ve filed bankruptcy?
So, you’ve been there too, huh? I understand. Been there and done that, but I have encouraging news, you can bounce back financially from a bankruptcy.
Read more: Financial Lessons That Led to Bankruptcy
Read more: Becoming Creditworthy After Bankruptcy
Note: The longer negative items remain on your credit report, the impact on your score will lessen over time. Your score can recover from inquiries, late payments, judgments, collections, and bankruptcy — it will just take time!
Why do I need a good credit score?
You need a good score because it can save you money!
Without a good score, you will almost always pay more on any type of loans or credit cards. Good interest rates are available for those who use credit wisely and only when needed.
Consider the scenarios below:
Trina
Trina 780 score falls in the excellent category. She has a solid payment history, low utilization, and has never had any negative reporting to her credit report.
Trina has balanced paying off her cards in full each month. She is now ready to shop rates (a single inquiry).
Awesome State Bank is offering a mortgage interest rate of 3.6% on a $165,000 loan.
Based on this information alone, she will make a monthly payment of $750.16 or less (this amount could be reduced by her down payment).
The total amount of interest she will pay for the 30-year loan will total $105,059.34.
Alisha
We will apply the same scenario to Alisha whose score falls into the fair category at 670.
Alisha has had a few mishaps, but over the last few years, she’s improved her utilization by paying off some of her credit cards.
The amount of credit she has is still pretty high, but she’s not behind on any of her payments. She is now ready to shop rates (a single inquiry).
Awesome State Bank is offering a mortgage interest rate of 4.5% on the same $165,000 loan that Trina sought.
She will make a monthly payment of $836.03 or less (this amount could be reduced by her down payment).
The total amount of interest she will pay over the 30-year loan will total $139,971.07.
In Comparison
As you can see, Awesome State Bank is going to charge Alisha $34,911.73 more than they will charge Trina for the same loan amount.
Of course, these situations may vary based on the type of mortgages these ladies are seeking and their down payment; however, it gives a rough idea of how credit scores can inflate the cost of major purchases.
The amount of interest paid also affects their monthly mortgage payment. The more money they are paying for their homes each month — the less they are able to save!
Put the numbers in and see how your situation would check out if you were to apply for a mortgage today using Bankrate‘s mortgage calculator.
What do I do to repair my credit score?
If you haven’t filed bankruptcy, it’s possible to turn things around. Here is a quick rundown of things you need to do to repair your credit score before things get worse:
- If you are currently behind on any loans or cards, call your creditors and work out a plan to get current on all balances owed. Once you’re caught up, the longer you pay your bills on time after your initial late payment, the more your score will improve.
- Keep balances low on all cards. Remember your utilization ratio is important. Thirty percent or less is what you want to keep in mind. Keep the amount owed on each card less than 30 percent and the amount among all of your debt owed under 30 percent for the best results.
- Do not close old accounts!
- Don’t open extra cards to increase your utilization ratio if you don’t need them. Remember those hard inquiries mentioned earlier. They have an impact on your score too.
- Schedule auto-payments so that any amounts on your cards will be paid on time and in full each month.
- If you do carry a balance, make sure you pay more than the minimum owed and create a plan to pay off the debt in the shortest amount of time.
By following the tips listed above, you won’t see an immediate change in your credit score. However, if you stay consistent as the length of time passes, you will see your credit score recover. It takes a while to build a solid score, but if you stick with it, you’ll reap the benefits of being financially responsible with your credit.