What is Credit?
Credit is essentially a measure of how ‘able’ someone is to repay a loan. Lenders (usually banks) can more accurately assess how much money they should let someone borrow based on their credit score, which is a number between 300-850. 300 is considered a “poor” score and 850 is considered “excellent.” There are two types of credit; installment loans (i.e. student loans or car loans) and revolving credit (credit cards). So what do your loans and credit cards have to do with your credit score? Where does your credit score come from and how is it calculated?
Your Credit Score (Also called FICO Score)
Anyone who’s ever taken out school loans or obtained a credit card has begun ‘building credit.’ This means that your credit activities are now being tracked by consumer reporting agencies, the largest of which are Equifax, TransUnion, and Experian. When you apply for a loan or a credit card, you’ll have to provide your basic information as well as your social security number, and whoever is providing you with the loan or line of credit will ‘run’ your credit score. This means they are running a report of your financial history through a consumer reporting agency that will tell them how able you are to pay back the money they are lending to you. Although these consumer reporting agencies don’t disclose their exact algorithm, it is known that your credit score is based on the following:
1. Credit Report (history of repayment)
Your credit report (different from your credit score) details how many on-time, late, or missed payments you’ve made in the past seven years, as is required by the Fair Credit Reporting Act (FCRA). Your credit report is weighted heavier than any of the other 4 factors, and it is therefore regarded as being the most important factor in calculating a person’s credit score.
2. Amounts Owed
This is an evaluation of your outstanding debt; student loans, car loans, etc. It is also an evaluation of how much of your revolving credit you regularly use. Are all of your credit cards maxed out or do you regularly keep them paid down? A good rule of thumb is to use 30% or less of your available credit limit. (i.e. if your available credit limit is $3000, you should keep your balance at or below $900 at any given time). This is the second most weighted factor in determining your credit score.
3. Length of Credit History
The longer you’ve had good credit, the better. For this reason, it can be beneficial to keep one credit account open even if you don’t use it – however, it should be noted that having multiple open accounts that are not in use can be counted against you, so go ahead and close the accounts you don’t use regularly.
4. New Credit
Opening a lot of new lines of credit in a short period of time will reflect negatively on your credit – it implies that a person cannot obtain a high enough credit limit with just one credit card, so they are seeking to open multiple lines of credit to suffice for whatever their expenses may be. This brings up another important principle that we will talk about later – the difference between a ‘soft’ and ‘hard’ hit on your credit and why it’s important not to have too many ‘hard’ hits within a short time period.
5. Types of Credit in Use
The algorithm considers what kinds of credit you use, so it’s a good idea to have both revolving and installment lines of credit to build a healthy credit score – although not more important than being able to make all of your minimum payments on time.
What is a hard vs soft ‘hit’ (also called an ‘inquiry’ or a ‘pull’) on my credit?
Whenever a potential creditor runs your credit score, this is considered a ‘hard hit’ or, ‘hard inquiry’. When someone runs a credit report, (this is only a report of your repayment history), this is a ‘soft hit’ and does not require your social security number. Any time you apply for a credit card, a car loan, an apartment, for example,. the creditor is likely going to have to run a hard hit on your credit. so this is one of the most important questions to ask any time you give your social security number to someone to apply for anything! They are probably running a hard inquiry! t’s important to make sure you know when a hard inquiry is being run on your credit and to make sure that you’re not having multiple hard hits within a few months of each other. A good rule of thumb is to have no more than two hard credit inquiries per year. It is also good to note that hard inquiries only stay on your credit report for two years.
How can I check my credit score without running a ‘hard hit’?
This is a great question and one that is commonly asked. You’ve seen commercials for Credit Karma and Credit Sesame advertising your ‘free credit score now,’ and while you can run your credit score through these websites, it will be counted as a ‘hard inquiry’. A better idea is to run your credit report, since ‘soft hits’ don’t count negatively against your credit score. Your credit report won’t give you your exact score, but it can give you a pretty accurate idea. The best way to run your credit report is through the Federal Trade Commission website. The government entitles you to one free credit report every year, and it’s safest to run your information through their website. To go straight to their authorized page, go to Annual Credit Report. You can also visit any of the three major consumer reporting agencies; Equifax, TransUnion and Experian, all of which have websites where you can run your credit report, or a credit score. These websites also provide tools and resources to help you further understand your credit.
So in conclusion, your credit score is a calculation of many factors, the most heavily weighted of which are your credit report (payment history) and outstanding debt. When you apply for a credit card, your credit limit (the maximum amount that you can charge to your card) is determined entirely by your credit score and your gross income (your income before taxes). The lender (usually the bank) will sometimes verify this by having you provide your most recent pay stub, so be prepared for this.