Understanding the Concept of Credit Scores and Credit Report
Credit scores are numerical analysis of the information obtained from a person’s credit files. It simply expresses the creditworthiness of a person seeking to use some sort of credit product indicating the likelihood that the person will pay his bills. In the United States, Credit scores are generally obtained from the credit report generated from the three popular credit reporting agencies (Equifax, Experian and TransUnion).
Credit Report is a detailed collection and reporting of a person’s credit history. It represents how a person have utilized the credit product they were approved to use in the past. Usually Credit reporting agencies like Equifax, Transunion, and Experian collect different data about a person’s Payment History on outstanding debt, Credit Utilization Ratio which implies an individual’s dependency on credit product, Derogatory Remarks like Judgements and collections, the age of Credit History that is how long the individual has used credit products, the number of Credit Inquiries which indicates how often an individual seeks out a credit product, Credit Product Mix and even the total number of Credit Accounts a person has at a given point in time.
To better understand the concept around credit, let’s take Mr. John Doe for instance who has never used credit before; he has no credit report files and thus have no credit scores. He intends to buy a House worth $200K sometime in the future and he does not have such funds saved up anywhere. How can he go about achieving his American dream of someday becoming a homeowner?
Mr. John Doe has 2 options.
- Work really hard day and night, come rain or shine, weekends and holidays, 24/7, 365 days in a year in order to save up some money and be able to purchase his dream home.
Or
- He can start building his credit file, thus creating credit data which can be used to generate a credit score that will show lenders how credit worthy he is.
After analyzing his options, Mr. John Doe decides that option #2 is his best bet in achieving his American Dream. But he wonders, how do I begin this journey of building my credit file? He then decides to go speak to his personal banker Joe Public who advises him that in order to build credit file he has to use some sort of credit product, make payments on them over time and use them wisely in order to be analyzed and to be used to determine how creditworthy he can be. To achieve this goal, Banker Joe Public suggested the following steps.
- Secured Credit Card/Loan: Personal banker Joe Public suggested to Mr. John Doe that since he has never used credit before and to avoid being denied approval on credit when he applies, the best way to get started is to use a secured credit card/secured Loan. This is basically a type of credit that is backed by a refundable deposit in lure of a credit limit. With this type of credit, the borrower places his own money into a credit account which he then gets to use and treat it like a credit card or loan, making regular payments just like he/she would if approved to use an unsecured credit card or loan. After a period of using this form of secured credit and making regular payments as stipulated by the credit issuer, the individual then gets approved to use an unsecured credit card/loan and the secured fund is then refunded back to him/her.
- Make Payments on Time: Banker Joe Public also advised Mr. John Doe to always make his credit card payments on time. This he said is very important because it shows the creditor that you are a responsible borrower and that you take care of your business. Failure to make payments on time will hurt your credit score. It is important to pay attention to due dates and try to pay off your credit balance. However in the event that you are not capable of paying off the balance, try and pay the minimum amount requested which is usually just a little percentage of the overall debt balance. Timely payments make up 35% of credit score!
- Keep Balance Low: It is always best to pay off the entire balance on your credit card every month which in turns saves you a lot of money over time on interest. However, there is a good rule of thumb that suggests paying down your credit balance and maintaining a low credit utilization ratio of less than 30% of the entire balance. Maintaining a low utilization ratio on your revolving accounts indicates to lenders that you are not dependent on credit and as such you are not a credit risk. The total amount owed or credit utilization ratio make up 30% of credit score.
- Build a Healthy Length of Credit History: When you open an account and you continue to make on time payments while keeping your utilization ratio low, try and keep that credit account open and avoid closing out old credit account if possible. Lenders put into consideration how long you have been using credit products. In the event that you do not want to continue using a credit card, still leave the credit card open for as long as you can because the good credit history you have created can be reported for up to 7 years. A good strategy that can be adopted is cutting up the credit card to avoid further using it. However pay close attention that the lender does not end up closing it out due to inactivity. Keeping a credit card open also helps with the total credit limit you have which is good when considering your utilization ratio.
- Credit Mix: In order to continue with the goal of building a good credit, it is important to keep a good credit mix. This simply means using different types of credit products which can be divided into two broad categories; revolving credit and installment accounts. Revolving credit accounts are credit accounts that allow you to use them and then make payments to them allowing you the opportunity to use it again over and over. Good examples of revolving credit are: Credit Cards, Line of Credit. Installment accounts on the other hand are credit accounts that are repaid over time with a set number of scheduled payments. When approved for an installment loan, an individual usually receives a lump sum and then begins to make payment but cannot reuse it again after payments are made. A good example of Installment loans are Auto, Personal and Mortgage loans. Credit mix makes up 10% of credit score.
- Credit Inquiry: With credit inquiry, an institution request for the credit report information from a reporting agency in order to make a credit approval decision. An individual can also make a credit inquiry requesting information about their credit file. The difference between when a person request for his/her credit file and when an institution request for it for credit approval purposes is what is known as a Soft or Hard Inquiry. A Soft Inquiry is when a person makes request for his/her credit file mostly for educational purposes and to monitor their credit file. This does not affect or impact the credit score. A Hard Inquiry on the other hand is when an institution request for an individual’s credit file for credit approval purposes. A hard inquiry affects a person’s credit score and remains on the credit file for at least 2 years. Credit Inquiry makes up 10% of credit score.
