- Credit Basics

What is "credit" and what does it mean?

Webster's Dictionary says "credit" derives from the Latin creditum, meaning something entrusted to another, such as a loan, or reliance on the truth or reality of something. It is also related to the Latin creditus or credere, meaning to believe or entrust.

Other sources define "credit" as a privilege granted for the purpose of extending time to make payment on a debt (e.g., through a loan or use of a credit card or similar device), and also as referring to the "financial worthiness" of a borrower. In other words, the history of whether a borrower has met financial obligations on time in the past.

Obviously "credit" can also refer to credit for a favor, credit for a movie role, credit for taking a course in school, etc. There are many definitions, but the one of interest to us here has to do with one's ""credit worthiness": one who is creditworthy is financially sound enough (via reputation or income or assets) to justify the extension of credit (i.e. a loan of some kind)

"How good is your credit" thus refers to numerous things that basically define whether you can be counted on to do what you promise, especially in a financial sense. What is your reputation? Are you believable and trustworthy? To the financial world, credit is the opportunity to get something now by promising to pay for it later.

Reputation is the key element here, and many people do not realize this. It can take many years to build up a reputation for good credit (or honesty), but it only takes a short time to lose that reputation. Once lost, it can be very difficult to reestablish good credit.


Credit can be your friend or foe

Credit can be a valuable friend, but it can also be a nasty foe. It all depends on how you use it and how well you live up to your end of the bargain. That is, do you honor the credit commitments you make, or do you not.

Unfortunately, credit is widely misunderstood and, perhaps even more to the point, widely misused. Opening up numerous lines of credit (e.g., credit cards), maxing out lines of credit, making payments late (or skipping them), and defaulting on loans or other payments when due can lead to devastating results. These results can cut off your future options for borrowing, increase your cost of borrowing, and hurt in other seemingly unrelated ways (e.g., loss of a job, loss of job opportunities, or even loss of a marriage to name a few).


Types of credit

There are two general types of "credit" or "loans":
  • Secured Credit: In this case the lender has some protection if you default on your loan. Secured loans are usually backed by property, not just your word. Auto loans and home mortgages fall into this category. Interest rates for a secured credit is usually lower, and the term of the loan may be longer, because the lender's risk of loss is reduced by his ability to reclaim (and sell if necessary) whatever you have bought with the credit.
  • Unsecured Credit: This type of credit is usually more expensive (i.e., has a higher interest rate), with a shorter term due to the higher risk assumed by the lender. The most frequent example of unsecured credit is the use of credit cards. With this type of credit, it is only your word that the lender can rely on. If you default, there are no assets the lender can seize to recoup his losses.

How do creditors determine your credit?

Lenders generally look at the following items in evaluating whether or not to extend you new credit.
  • Your reputation and character: Are you reliable and honest? Do you do what you promise?
  • Your capacity to carry debt: What is your income, and what are your other obligations (existing debt, leases, rental agreements, etc.)
  • What is your collateral: What cash or other property (e.g., auto, home, equipment, etc.) could be used to repay the debt if you default?

What is your credit history?

The fastest way for a creditor to evaluate your reputation and character is by looking at your credit history. So a number of years ago, several independent "agencies" or companies decided to make a business out of collecting, organizing and reporting on the credit history of essentially all American consumers.

The most well known of these credit-reporting companies are TransUnion, Experian and Equifax. These three companies collect all the credit-related data they can get their hands on, organize it by individual consumer and type of activity (e.g., loan application, late payment, charge off, on-time payment, etc.), and then sell the resulting "credit reports" to banks and other organizations who are making decisions about whether or not to make new loans, issue credit cards, rent to new tenants, underwrite new insurance policies, hire new employees, etc.

The concept of using mathematics and statistics to quantify credit history and determine a single "credit score" for predicting risk was pioneered about 40 years ago by a company named Fair Issac Company. Their system was found to be a fairly accurate predictor of financial risk, and is now used by most lenders, insurers, landlords and employers. The "credit score" now in wide use is often referred to by the initials of Fair Issac Company as the FICO credit score.

Today, your credit score is perhaps the most important tool available to you when looking to buy a car or a house, rent an apartment, or qualify for a job. Like it or not, your credit score can be either your best friend or your worst enemy; it is a major determinant of whether or not you get the credit you seek, as well as what it will cost you (i.e., the interest rate you will pay).  We'll explain more about your Credit Score in a few minutes.


Your Credit Report

Your credit report is basically a history of your experience with various creditors over the years. It is a record of whether you have met or have not met your financial commitments. Based on this information, you are assigned a "credit score." People with higher scores generally get the best terms, including lower interest rates and reduced minimum down payments. People with low credit scores can usually pay higher interest rates and possibly additional fees or insurance; or they may be denied credit altogether.


What information is contained in your credit report?
  • Personal identification information: Such as your name, Social Security number, addresses (past and present), and your most recent employment history.
  • Public-record information: These can be tax liens, judgments, bankruptcies, child-support orders, and other official information.
  • Collection activity: This is for accounts that have been sent to the collection agencies for handling.
  • Information about each credit account: It states whether the accounts are open or closed, whom you owe, the type of account (such as mortgage or installment loan), whether the account is joint, or just in your name, how much you owe, your monthly payment, how you've paid (on time or late), and your credit limits.
  • A list of companies that have requested your credit file: This may have been so that they could send you promotional material, or it may have been because you applied for a new loan or credit card. Note that promotional inquiries do not show up on the report that prospective creditors see, just on the report that you yourself request.
  • An optional message from you: This is if you want to explain any extenuating circumstances for any negative listings on your report.
  • An optional credit score: The credit score is technically not part of the credit report, but rather is an add-on that you have to ask for.
 Your Credit Score

Interpreting your Credit Report is a subjective process; it takes time to read and understand all of the information it contains. So it's no wonder that creditors have turned to using the Credit Score due to its apparent simplicity.

Your Credit Score is a 3-digit number that is calculated from the information in your Credit Report. Right or wrong, it is much faster and easier for a creditor to make a decision based on your Credit Score than it is for him to wade through and interpret all of the data contained in the Credit Report itself.

While the exact formulas used for calculating a Credit Score are secret and protected, we do know the approximate percentages that various factors contribute to the final score:>
  • Payment history (35%) - The largest factor determined on your FICO score is your basic payment history. The number of unpaid bills you have, any bills sent to collection, bankruptcies, etc. The more recent the problem, the lower your score.
  • Outstanding Debt (30%) - Are your cards maxed out? High balances or, more precisely, balances that are close to your credit limit, can negatively affect your score.
  • Length of your credit history (15%) - How long have your accounts been open? The longer the better.
  • Recent inquiries (10%) - Every time you apply for credit of any kind you create an inquiry on your credit report. Multiple inquiries negatively affect your score.
  • Types of credit in use (10%) - Installment vs. revolving accounts, for example. How many and how much.
As mentioned earlier, three major companies or bureaus dominate the market for supplying American lenders with credit scores and credit reports. When you apply for credit, the credit score information does not come directly from FICO (Fair Issac Co); instead each bureau has its own version, sometimes with its own name (in an effort to make themselves look different from the competition).
  • Equifax currently refers to their score as a FICO score
  • Trans Union currently calls their scores Empirica
  • Experian calls their score VantageScore
You don't control which agency supplies the credit report and credit score to your bank, auto dealer, mortgage company, landlord, potential employer, etc. They probably have an established relationship with one of the reporting agencies, and that is whom they will go to for the latest information on you. So the smart thing is for you to monitor your score at each of the agencies, and do what you can to keep it moving upward.


Steps you can take to improve your Credit Score and your "credit".

Now that you know how your score is calculated, you can begin making changes to improve it. Fortunately, the best things you can do are simple.
  • Pay your bills on time. Sounds simple, but this is the biggest thing you can do to keep your score high. Delinquent payments and collections have a major negative impact on a score.
  • Keep your balances low on unsecured revolving debt like credit cards. High outstanding balances can affect a score.
  • The amount of your unused credit is an important factor in calculating your score. You should only apply for credit that you need.
  • Make sure the information in your credit report is correct. If it's not, dispute it with the credit agencies and/or with the creditor directly.
Removing negative items on your credit reports has the biggest impact on your FICO score. Generally, negative items stay on your reports for seven years, but you can hire a professional credit report repair service such as Lexington Law Firm to do it for you and possibly remove items faster.

You can try to understand the laws and do this work yourself, but we have found it's so much easier to have someone do it for you. We strongly recommend using Lexington Law Firm. They are truly the industry leaders.
 

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