What is a credit score, how is it calculated, what you can do about it and how to get started:
Whether or not you get a loan, and how much you will have to pay in interest, depends on your "credit score." Your credit score is a single number, usually between 300 and 850. The higher your number the easier it will be for you to get credit at good interest rates. Ideally, you would like to be over 700.
In truth, there is no one single credit score. You have several. All three major "Credit Reporting Agencies" have their own proprietary "algorithms" for determining your credit score. A company called "Fair Isaac" also gives you a score called a "FICO" score that is used by most mortgage lenders.
You can get free credit reports (www.annualcreditreport.com) from all three agencies but this will usually not include useful scores. However other sites can help with this. The Wall Street Journal has reviewed three sites that fill in the gaps. One way or another, they give you a free peek at your estimated credit score in the hope that you will buy more services and information. I checked all three sites and found that “free” applied only to two of them, despite what the Journal article said.
According to the Wall Street Journal these sites "...offer a window into the key factors that go into calculating your score, what you can do to improve them and how your credit stacks up against others."
The first site, www.credit.com, won’t give you anything free as far as I can tell unless you subscribe to one of several different credit checking services they offer. The cheapest one will cost you almost $120 a year.
The two other sites, www.creditkarma.com and www.quizzle.com are actually free. Quizzle, in particular, offers several free tools, like budgeting tools and credit repair tools, that you might find useful. We did not try them since you have to register.
Here is what you have to do to improve your credit score:
- Pay your bills on time.
The single most important factor in your credit score (but not the only important one) is your payment history. Missing payments, or paying the minimum due each time on credit cards, will lower your credit score, and it can take years of improved payment activity to increase it. If you have used debt managemnt plans or filed bankruptcy, your score will be severely impacted for years.
One problem with this part of your score can be mistakes on your file. They are common. You are entitled to a free credit report from every credit reporting agency once a year. You should collect these reports and check for errors. If you find any, go to our credit repair section [click here] for information on how to get it corrected. This can take a lot of time, but if you are in a hurry, you may be able to get your prospective lender to speed things along so that your loan clears at the best possible rate.
- Be careful about how you borrow.
The amount you owe is the other major component of any credit score. But it is not simply the total amount you owe that is taken into account. Most credit score algorithms look at whether or not your credit is "maxed out." So if you have a line of credit on your home that is borrowed up to the maximum allowed, or you have borrowed all you can on your credit cards, then your score will be lower. It is better to have three credit cards with a credit limit of $2,000 each on which you have balances of $1,000 each than one credit card with a limit of $3,000 which is "maxed out."
The next three items are not as important as the first two, but they should also be taken into account.
- Be careful of too much credit activity.
Even inquiring about borrowing from different lenders can lower your score. (The credit reporting agencies record every inquiry made on your file.) If the agencies see a lot of activity, they deduct points from your credit score. Every time you open a new line of credit, your score is impacted -- at least temporarily. So, when the store you are in offers you a deal for signing up for a new credit card, do not do it unless the deal is really good -- or unless you do not care if your credit score goes down temporarily.
- Maintain many different types of accounts.
If your only credit is in credit cards you will get a lower score. Lenders like to see someone with experience at handling different types of loans, like car loans, mortgage loans, and installment plans, as well as credit cards.
- Live long and prosper.
The length and variety of your credit history is also important. If you are one of those people who pays cash whenever they can and hates to borrow, your credit score will be lower. Having many different forms of credit in your history -- including multiple credit cards -- will (if managed without defaults), convince lenders that you are a sophisticated user of credit. In short, this will help them see you as a good customer.
The fact is that if you do not have credit cards, or have not been borrowing in other ways, the major Credit Reporting Agencies (CRA's) might not have enough information to give you a traditional credit rating. Some estimates say that as many as 50 million American adults may fall into this category.
The simplest thing to do to establish credit is to "piggy back" on someone else's good credit. You could, for example, become an "authorized user" on a relative's credit card. Even if you do not in fact use the card, you will get credit for paying bills on time and being responsible (IF your relative acts responsibly). Do NOT however, fall for the pitch of some companies that claim they will add your name to a legitimate account for a fee. The credit reporting agencies are wise to this scam and you will likely waste your money.
You can also get someone with good credit, usually a relative, to "co-sign" on your credit card or any other loan. As you pay back the loan, you will build your credit rating. Don't forget that the person co-signing is just as responsible for your payments as you are, and should you default, the lender will ding their credit rating and go after them for payments. Make sure anyone who co-signs understands this.
Secured credit cards are another way to establish your credit rating. With these cards you make a deposit up front and that is your credit limit. Every month you get a bill and can choose whether to pay it off or just to pay part of it. All this gets reported as if it were a regular credit card and builds your credit rating. (The terms of these cards vary widely -- some charge high fees or interest from day one, while others pay interest on your deposit -- so be careful to compare terms before you sign.)
Some of the CRA's (Transunion, Experian and Equifax, to name three) are working on providing alternate credit scores for some people, based on what they call "non traditional" information, like how well you have been paying rent, utility and insurance payments. These payments are not typically reported to the CRA's. But if this has not yet happened and you need a credit rating to borrow, there is a way you can set one up for yourself.
Pay Rent Build Credit, Inc (www.PRBC.com) is a relatively new organization for people who do not have credit ratings. It works in one of two ways. You can sign up with them to pay your bills online and they will use that information to build a credit score for you. Or you can submit paid bills to them so they can establish your history. They charge for this service. They also charge lenders who inquire about your rating for a report, as do the other CRA's.
For many people, this may be a good way to get a loan they might not otherwise have gotten, or, just as important, to get a lower interest rate.