Life is just easier with good credit. If you establish a strong credit history, it's easier and cheaper to buy a house, finance or lease a car, rent an apartment, or get credit cards.
Surprisingly, few Americans have a thorough understanding of how credit works. Many are unsure of what information is and isn't on their credit report, and don't know what credit score is the best to use or what makes it go up and down. With that in mind, here's what you need to know about credit in order to maximize your own.
What's in your credit report?
In order to keep track of your credit behavior, there are three credit "bureaus" – Equifax, Experian, and TransUnion – which maintain credit reports for all American consumers. In theory, all three reports should contain the same information, but there are usually some minor differences.
Your credit report contains several types of information, including:
- Identifying information – Your credit report contains your name, address, Social Security number, and date of birth. This information is for identification purposes only, and doesn't affect lending decisions.
- Employment information – The name and addresses of your current and former employers
- Credit accounts – For each of your credit accounts, your credit report will list the type of account (mortgage, auto loan, credit card, etc.), the date you opened it, its credit limit, current balance, and payment history.
- Credit inquiries – When you apply for credit, it results in an "inquiry". Only voluntary credit inquiries (initiated by you) from the last two years are visible to creditors.
- Public records – The credit bureaus obtain information from state and county courts involving bankruptcies, foreclosures, lawsuits, liens, and judgements.
- Collection accounts – If you have overdue debt that was purchased by a collection agency, it appears on your credit report as well.
It's also worth noting that (most) negative information stays on your credit report for seven years. Even if you still owe a debt collector money more than seven years after the account originally became delinquent, they can no longer report it to the credit bureaus.
How to get your credit report (without paying for it or buying anything else)
There is no shortage of websites advertising "free credit reports", but they generally want you to sign up for a trial of their credit monitoring service.
However, under the current law, you are entitled to one free copy of your credit report every year with no strings attached from each of the three credit bureaus. The only way to request your free credit reports under your legal entitlement is through www.annualcreditreport.com.
It's important to check your credit report regularly, as many reports contain inaccurate information. And, your credit report can let you know if your identity has been compromised.
What is a credit score and what is in yours?
When you go apply for say, a credit card, it wouldn't be practical for the credit card company to go through your credit report line by line and evaluate your entire history before making a decision. So, in order to simplify the process, credit scores are generated in order to provide a "snapshot" of your overall credit profile.
There are several companies that produce credit scoring models, but the most universally recognized is the FICO score from the Fair Isaac Corporation, which is used in more than 90% of lending decisions.
FICO scores range from a low of 300 to a maximum of 850, with higher scores being better. Scores between 500 and 800 are most common, and different lenders set their own standards as far as minimum score requirements. In other words, a particular mortgage lender may only accept borrowers with a 720 or higher, while another may only require a 600.
The actual FICO formula is a closely guarded secret, but the company does provide the five categories involved and their respective weights.
- Payment history (35% of FICO score) – As you might expect, whether or not you pay your bills on time has the most influence on your credit score.
- Amounts owed (30%) – This refers more to your balances relative to your credit limits and original loan balances than it does to the actual dollar amounts you owe.
- Length of credit history (15%) – This takes into account information such as the age of your oldest credit account, the average age of all accounts, and the age of your individual credit accounts.
- New credit (10%) – Too many credit inquiries can negatively impact your score, and so can opening too many new accounts.
- Types of credit used (10%) – This measures whether or not you have a healthy mix of different credit account types (mortgage, auto, credit cards, etc.)
It's also important to note what isn't factored into your credit score. Your race, color, religion, sex, and marital status have no bearing on your score. And, despite the popular misconceptions, your age and salary don't impact your score either. In a nutshell, your credit score is only made up of the information listed above.
There is no formal definition of what a "good" credit score is, but generally speaking, FICO scores below 620 are considered bad, and scores about 740 are considered to be excellent and will usually qualify you for the best interest rates.
The bottom line on credit
The best way to begin maximizing your credit is to understand how your credit score is calculated and adjust your spending and borrowing habits accordingly. Obtaining a lower interest rate on a major purchase like a home can literally mean tens of thousands of dollars in savings, so it can certainly be worth the effort.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at firstname.lastname@example.org. Thanks -- and Fool on!