Chances are you’ve heard of a credit score, but do you actually know what it means? Why do teenagers and young adults need good credit scores? And finally, what can you do to establish good credit?
Let’s start with the basics.
What Is A Credit Rating?
Investopedia.com informs us that when you use “credit,” you are borrowing money that you plan to and promise to pay back within a specified period of time. When you get credit from a lender, you agree to pay back the amount you spent, plus applicable finance charges, at an agreed-upon time. A credit score is a mathematical method to determine how likely an individual is to pay back the money he or she has borrowed.
There are three major credit bureaus in the United States, which are Equifax, TransUnion, and Experian. Credit bureaus that issue these scores all have different evaluation systems based on different factors. Some may take into consideration only the information contained in your credit report, while some may look at other things. The primary factors used to calculate an individual’s credit score are as follows:
- credit payment history
- current debts
- time length of credit history
- credit type mix
- frequency of applications for new credit.
Because the scoring systems are based on different weighted criteria, the three credit bureaus may issue differing scores for an individual, even though the scores are based on the same credit report information.
What Is A FICO Score?
You may hear the term FICO score in reference to your credit score, as these two terms are essentially synonymous, as in they mean the same thing. FICO is an acronym for the Fair Isaacs Corporation, the creator of the software used to calculate credit scores.
Scores range between 350 (extremely high risk) and 850 (extremely low risk). Here is a breakdown of the distribution of scores for the American population in 2003:
What About A Credit Rating?
In addition to using credit (FICO) scores, most countries like the U.S. and Canada use a scale of 0-9 to rate your personal credit. On this scale, each number is preceded by one of two letters:
- “I” signifies installment credit like home or auto financing
- “R” stands for revolving credit like a credit card
Each business you seek credit with will issue its own rating for individuals. For example, you may have an R1 rating with Visa (the highest level of credit rating), but you might simultaneously have an R5 from MasterCard if you failed to pay your MasterCard bill for many months. Although the “R” and “I” systems are still in use, the prevailing trend is to move away from this multiple rating scale toward the single digit FICO score. Nevertheless, here is how the scale breaks down:
What Makes Up Your Credit Score?
When you borrow money, your lender sends information to a credit bureau which details, in the form of a credit report, how well you handled your debt. Remember debt is money you owe. From the information in the credit report, the bureau determines a credit score based on five major factors:
- previous credit performance
- current level of indebtedness
- time credit has been in use
- types of credit available
- pursuit of new credit
Although all these factors are included in credit score calculations, they are not given equal weighting. Here is how the weighting breaks down:
The pie graph basically illustrates that your credit rating is most affected by your how well you paid off your debt in the past. Although there are many ways you can improve your credit score, the factor that can boost your credit rating the most is having a past that shows you pay off your debts fairly quickly.
In addition, maintaining low levels of indebtedness, (which means not keeping huge balances on your credit cards or other lines of credit), having a long credit history, and refraining from constantly applying for additional credit will all help your credit score.
Why Your Credit Rating Is Important
When you apply for a credit card, mortgage or even a phone(land line and cell phones), your credit rating is checked. Credit reporting makes it possible for stores to accept checks, for banks to issue credit or debit cards, and for companies to manage their operations. Depending on your credit score, lenders will determine what risk you pose to them. They want to know if you are a good risk to pay back their money.
According to financial theory, increased credit risk means that a risk premium must be added to the price at which money is borrowed. Basically, if you have a poor credit score, lenders will not shun you, unless your score is just ridiculously awful. Instead, they will lend you money at a higher rate than the one paid by someone with a better credit score. You will pay more to borrow money because your credit score stinks.
The table below shows how individuals with varying credit scores will pay dramatically different interest rates on similar mortgage amounts. The difference in interest will then have a large impact on your monthly payments, payments which pay off both interest and principal. As you can see, your credit score can affect your mortgage in many ways:
What are the Four Types of Credit?
Experian.com explains that there are four types of credit:
1. Revolving Credit
With revolving credit, you are given a maximum credit limit, and you can make charges up to that limit. Each month, you carry a balance (or revolve the debt) and make a payment. Most credit cards are a form of revolving credit.
2. Charge Cards
While they often look like revolving credit cards and are used in the same way, charge accounts differ in that you must pay the total balance every month.
3. Service Credit
Your agreements with service providers are all credit arrangements. You receive electricity, cellular phone service, gym membership, etc., with the agreement that you will pay for them each month. Not all service accounts are reported in your credit history.
4. Installment Credit
With installment credit, a creditor loans you a specific amount of money, and you agree to repay the money and interest in regular installments of a fixed amount over a set period of time. Car loans and mortgages are two examples of installment credit.
How Do You Establish Credit?
Getting your first line of credit can sometimes be challenging. If you don’t have a credit history or if you have filed for bankruptcy in the past, credit grantors may be reluctant to extend you credit.
You can establish credit in three ways:
- Start small and build up, a good first step being a local department store (Target, Dillards) or bank. Before you apply, ask the credit grantor if it regularly reports your bill-paying history to a credit reporting company, which will help you establish a history of responsible credit use.
- Get a cosigner; ask a parent, a family member or a friend with an established history of good credit to cosign a loan or credit card application for you. Make sure you pay as agreed, since you are putting your cosigner’s good credit at risk.
- Apply for a secured credit card. To obtain a secured credit card, you open and maintain a savings account as security for your line of credit, which is a percentage of your deposit.
What are tips for building credit?
1. Set a budget and live within it. Credit should not be used to live beyond your means = the money you bring in from work.
2. Always give complete, accurate and consistent identification on your credit applications. This information helps set up your credit history correctly from the beginning. It ensures that your new accounts will be matched to the correct report and minimizes the chance that your credit file will be incomplete.
3. Pay your bills on time. Late payments, called delinquencies, negatively affect your ability to get credit since they indicate a stronger likelihood that you will make late payments again or will be unable to pay your debts in the future.
4. Have some credit, but don’t have too much. Having no credit history is almost as bad as having a negative credit history, and you only need a few accounts reported to the credit reporting companies to demonstrate credit management.
5. Have a mixture of credit types. It is good to have a history of repaying an installment loan, but a revolving account demonstrates more clearly that you can responsibly manage credit.
6. Keep credit card balances low. Keeping your balances low compared with credit limits shows that you aren’t tempted to charge more than you can pay. By charging a small amount on at least one card and paying the balance on time, you will show that you can handle larger amounts of available credit.
7. Use caution when closing accounts. Closing an account isn’t always a good thing. It can result in an increase to your balance-to-limit ratio, making you appear to be an increased credit risk.
8. Be aware of your debt-to-income ratio. Mortgage lenders consider your monthly payments compared with your monthly income.
9. Demonstrate stability. Some creditors consider your length of employment, length of residence, whether you own or rent and if you have any savings in making credit decisions.
10. Contact your lenders if you fall behind on your payments. Many lenders will work with you to set up a different payment schedule or interest rate.
Many teens do not realize how important a good credit score will be during their years as adults. By making good choices in establishing credit, teens can save a lot of money by avoiding late fees, higher monthly payments, and bankruptcies.
Make good choices when you first start establishing credit so you can reap the financial benefits later.