A Basic Introduction to Credit

Do you have a credit card? A mortgage? Have you bought furniture where you do not have to pay for “two whole years! (o.a.c.)”? If so, you have a credit history, and it starts with your first financial transaction.

Credit is basically a loan to purchase goods you normally would not have enough cash to cover. Though there are many types, the two most familiar are:

• revolving credit, such as a credit card, which has no fixed payment method (besides a minimum amount);
• installment credit, such as a car loan, where you pay back a set amount every month.

How you handle your credit is recorded in your credit history.

What, I Have a Credit History?

So, did you apply for a loan for that sports car and get turned down? After the initial shock, your next thought would probably be, “Why didn't I get the loan?” You think back, and suddenly remember that time two years ago when you couldn't make ends meet, couldn't pay your bills, and defaulted on a loan. The creditors had your number on speed dial, demanding you pay them back.

Oops. All that information has been collected into your credit history. Account openings and closings, credit cards, loans, mortgages, even inquiries into your credit, it is all noted. Also recorded is how you pay credit back – on time, 30 days late, 60 days late, etc, all the way to if a collection agency has had to phone you. Financial information stays on your report for 2 to 10 years.

What is all this information compiled into? A credit report, of course.

What is Your Credit Report Used For?

There are three major credit reporting agencies: Equifax, TransUnion and Experian. These companies collect your information, and though they all compile them using their own methods, they all should be similar and accurate. They exist to help lenders know your creditworthiness, or ability to pay back loans.

Imagine you are a bank manager, and a customer asks you for a car loan. Because very few people will actually walk into a dealership with $30,000 in cash, they will come to you. Do you smile and give your client what he needs because he has a great looking haircut? Of course not. You order a report from one of the three agencies to see if he has a good history of paying his loans on time, and how much credit he currently has (too much, and he might not have the ability to pay you back.)

Based on a good credit report, lenders will feel secure in the knowledge that their loan will be paid back, plus interest. Ah, yes, interest. If you have an excellent report, you will be seen as low-risk for defaulting on loans, and you will be offered a lower interest rate. The opposite is true with a poor credit history: bankruptcy, unpaid loans and too much debt. A lender may be wary of your financial situation, and if you receive the loan, it'll likely be at a much higher interest rate, because of the perceived greater risk.

Be aware that there is no “good” or “bad” report. Each financial institution uses their own criteria to determine whether they will extend credit to you.

Yes, You are a Number - More Accurately, a Score

To simplify life for lenders, all your credit information and history is churned into a massive statistical machine and spat out as a credit score. Different scores are calculated depending on the type of loan you are applying for, and each credit reporting agency uses a slightly different method. However, most are modeled after the familiar FICO score, developed by Fair Isaac Corporation, which uses a score from 300 to 850. A higher number is a better score. The median is around 723. If you have a score above 760, you will get the best interest rates. Conversely, below 600 you will be seen as a credit risk, and interest on your loans will be much higher.

Yes, being assigned a number is a cold and impersonal way to be treated. It's better, though, than to receive cash based on your race or gender. In fact, it's illegal to do so. Scores remove emotion, your appearance and your views from the equation, and rates you solely on your finances. The numbers are based on your payment history, how much debt you currently carry, how long you've had credit, the types of credit you carry, and how many inquiries have been made on your report (inquires from yourself do not effect scores.) Credit scores usually do not take your employment and wage into account, though the lender might calculate that in. After all, having a score above 760 means nothing if you are currently unemployed!

Am I Allowed to See What Agencies Have Reported About Me?

Of course! In fact, by law, you can order your credit report for free once a year, from each of the three credit agencies. AnnualCreditReport.com is the only website that offers this service. The three agencies are:

Equifax: 800-685-1111

TransUnion: 800-916-8800

Experian: 888-397-3742

When checking your reports, look for any errors, and take a look at the list of financial institutions, lenders, employers and landlords who viewed your report. If you notice any inconsistencies or errors, contact the credit bureau that built your report. Credit scores are not included, but can be purchased for a small fee. Subscribing to ay credit monitoring system will do all this for you, gathering your information and scores every few months. Another good idea is to order one copy from a different agency every four months, so you can spot errors earlier.

With the Knowledge Comes the Power (to Raise Your Credit Score)

Now that you know the basics of credit, you have some idea of how to raise and maintain your score. Pay your bills on time, do not take on too much debt, and review your credit reports every year. Even if you have a poor credit history, being financially responsible now will raise your score. With that accomplished and your financial house in order, that sports car you've been eyeing can be yours. As an added bonus, you'll save thousands with a lower interest rate!