Starting from Scratch: How to Build Credit – Part 1

What is Credit?

By GreenPath Financial Wellness

At its core, credit is an agreement between an individual and a creditor, in which the individual receives something now with the understanding they will pay the creditor back later. This can come in a variety of forms, like a loan, a credit card, or a line of credit.

A credit report shows your credit history and the activity on all open credit accounts. This shows how you have handled credit accounts in the past as well as how you are currently handling credit. Things can typically stay on your credit report for between 2 and 10 years, if not longer if they are open and in good standing.  There are three credit bureaus that generate credit reports: Experian, Equifax, and TransUnion. It is possible that there may be differences between the three reports. Sometimes smaller banks, credit unions and collection agencies only report to one bureau and not all three so it is important to review all three. You can access free copies of your credit reports from all three credit bureaus at AnnualCreditReport.com. It is recommended you do so at least once a year to review for accuracy. Your credit report will typically include some personal information, like your address and employer, as well as history and information about your credit accounts, bankruptcies, and collection accounts, as well as a list of who has accessed your credit reports, which is known as credit inquiries. Your credit report does not include your income, or any assets or savings you may have.

Your credit score is a three-digit number that uses information from your credit report to help creditors predict how likely you are to pay them back as agreed if they choose to extend the credit you are requesting. Basically, creditors use your credit score to measure how risky it is for them to offer you this loan or give you a credit card with a certain available limit. Just because you have a high credit score, it does not mean you are financially healthy. It is possible to have a high credit score while carrying a LOT of debt and having no savings, just like it is possible to have a low credit score due to not having hardly any debt but being financially stable overall.

There are 5 factors that make up and impact your FICO credit score:

• 35% Payment History – Making every payment on time every month is one of the very best things you can do for you credit score.
• 30% Amounts Owed – Creditors want to see loan balances decreasing, not hovering or increasing over time. This can often happen with student loans or finance loans. Also, they factor in the number of accounts that have balances. Credit utilization specifically looks at revolving credit accounts – like a credit card – where your balance could go up one month or down the next. Credit utilization looks how much of your credit limit you are using. The more credit limit you are using, the more risk you are to a creditor, e.g. add up all of your revolving balances and divide them by the total of your revolving limits and that’s your utilization number. Ideally you do not want to use more than 30% of your limits at any time and ideally pay them off monthly.
• 15% Length of Credit History – This looks at how long your credit accounts have been open. This includes the age of your oldest account, the age of your newest account, and an average of all your accounts. The longer your credit history, the better.
• 10% New Credit – When you apply for credit, the creditor will typically do what is called a “hard inquiry,” which is when they dive deeper into your credit report and credit score to assess their risk. If you start applying for multiple new forms of credit frequently, this can be a red flag to creditors because they start to wonder what is going on that you suddenly need a new credit card one month, a new loan the next month, and now you are asking for another new credit card this month. Of course, we typically all need to apply for credit from time to time, which is understood. The key is being strategic with when you do apply, limiting those hard inquiries to only when you need it. Hard inquiries typically remain on your credit report for 2 years.
• 10% Credit Mix – Creditors want to see that you have a history of managing different forms of credit at the same time – for example, maybe a credit card and a car loan and a student loan. This is one of the smallest factors impacting your score, but it can help to have a well-rounded mixture of types of credit when they are all managed responsibly.

While it’s possible to have a 0 credit score if you have no credit history at all, if there is anything on the report the minimum score would typically be 300, which would be considered a poor credit score all the way through 579. Once you hit 580 through 669, that is considered fair. 670 – 739 starts being considered “good,” with 740-799 being very good, and 800+ falling under the category of excellent.  The average score in the United States varies a bit from year to year, but almost always falls somewhere in that “good” range of 670-739.

Why is credit important?

Your credit history or credit score can impact your ability to rent or purchase a home and turn on utilities in your name, and your ability to get AND keep some jobs. Some jobs will require a credit check before a job offer is extended, and some will periodically review your credit throughout your employment. This includes, but is not limited to, military clearances. Credit can also impact your ability to open a bank account, and of course to access loans or credit cards, as well as miscellaneous other things, including car insurance rates, cell phone plans, and more.

Even if you are able to get a credit card or loan with a lower credit score, you may pay more to have access to that credit. Creditors may charge you a higher interest rate as a way to account for the higher level of risk they are taking on by extending credit to you considering you have a lower score.

For example, if you take out a 5-year, car loan for $20,000, the interest rate for someone with a very good or excellent credit score can be 3.73% for a monthly payment of $366, reflecting a total interest paid of $1,952 over the course of the loan. Someone with a poor or fair credit score will be paying an interest rate of 16.05% for a monthly payment of $487, reflecting a total interest paid of $9,213 over the course of the loan.  As you can see, the interest rates, monthly payments, and total interest paid vary dramatically between the poor credit score and the very good or excellent score. In fact, someone with a very good or excellent score would save more than $7,000 in total interest paid compared to what they would have paid if their score was poor.  $7,000 is a lot of money – this is a prime example of why building credit history, and specifically positive credit history, is so important.  (Source: https://myfico.com/credit-education/calculators/loan-savings-calculator.)

In Part 2, we’ll talk about how to establish or build credit history.

This article is shared by our partners at GreenPath Financial Wellness, a trusted national non-profit.