Building Credit

It may not come as a surprise to hear that credit is checked before buying a home- with a majority of Americans relying on a home loan or mortgage, a bank or lender will perform a credit check to see how big of a risk it is to let someone borrow money, especially considering how much will need to be borrowed with such an expensive purchase. But did you know that your credit will most likely get checked during the application process of renting an apartment? Or when you decide to establish internet access for your home? Potential employers can also check your credit and some may use it to determine your status as a potential hire. Even with access to large amounts of cash, having bad or no credit at all could keep you from accessing certain goods or services.

When used responsibly, credit can provide an individual with more financial freedom. Good credit history might mean you can take out a loan without having to find a co-signer or that you can borrow money at lower, more favorable interest rates. Similar to a spending plan or a savings account, credit is simply a tool that when used correctly can have a positive influence on our personal finances. 

Credit Defined 

Credit can be summed up as your level of trustworthiness as a borrower. As you demonstrate good borrowing behavior- like paying on your debts regularly and on time every month- your trustworthiness grows. The better your credit is, the more likely it is that a lender or bank will be open to working with you and more likely to lend you money. If your past borrowing behavior is deemed risky, which could happen if you missed payments or borrowed a more money than it seemed like your current income situation could cover, a lender may not want be as willing to work with you. 

the impacts of credit 

Your track record as a borrower doesn't just stop at the likelihood of an individual or organization lending money to you. Credit has numerous impacts on your personal finances: 

• Credit is used to determine the interest rate you receive when borrowing. The lower the interest rate, the less interest you will pay. For long term purchases like cars and homes, where borrowing terms can range from 5-30 years, a lower interest rate can mean thousands of dollars in savings! 
• Your credit can be checked when applying for certain employment positions. Poor credit can sometimes be used to determine the trustworthiness or character of an applicant, and may result in a candidate getting passed over for a position. 
• Credit is checked when applying for an apartment or establishing certain utilities, like internet and cable. Regular payments are required for these expenses, and if you have demonstrated difficulties with monthly payments or holding up your end of a borrowing agreement, you could be denied these services. 

 

Now that you know the impact credit has on your personal finances, you are probably wondering how your trustworthiness as a borrower is reported or communicated to other people. Your record as a credit user is tracked through two mediums: your Credit Report and Credit Score.

Credit Report

A credit report is the official account of your borrowing record and history as a credit user. From a student perspective, think of a credit report as exams, projects, and papers you are assigned in class- the work you do in your role as a student.

Your credit report will feature your name, address, and other standard identifying information.

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After the overview of your personal data, a breakdown of your various credit accounts, active and inactive, will be listed. The accounts will be categorized based on accounts on good standing or with positive history and accounts with potentially negative history.

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 Finally, your report will show which lenders, creditors, or other parties have asked or inquired about your credit.

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Source: Experian 

Your full credit report typically is reviewed during the process of establishing new credit , such as applying for a loan or opening up a credit card.

The information on your credit report will change throughout your life as certain marks are required by law to be removed from your history after a set period of time. The following are types of records on your credit report and the duration of time they will stay on your history until removal:

• Credit inquires- 3 years
• Late or missed payments- 7 years
• Accounts in collection- 7 years
• Chapter 13 bankruptcy- 7 years
• Chapter 7 bankruptcy- 10 years

Positive marks can also change over time. While your open accounts in a positive status will remain on your report indefinitely, closed or inactive positive accounts will only stay on your report for 10 years.

There are three credit reporting agencies that oversee the compilation of your credit history:

• Equifax
• Experian
• Transunion

These three agencies or credit reporting bureaus may have different information on file associated with your credit history so it is important to review your report with each agency. You access your report with each bureau directly through their site, or through the website, AnnualCreditReport.com

As a consumer, you have the right to review your credit report through each bureau on an annual basis, penalty free. To review your credit on a somewhat regular basis, you may consider staggering when you check your credit report through each bureau, and pull once report at a time every four months. If you choose to review your credit report beyond your annual allotment, your report will most likely show the additional credit inquiry, which can negatively impact your credit.

You also have the right to dispute any information that is incorrect on your credit report. Disputing incorrect information entails documentation and other supporting evidence to back your claim of inaccuracy. You can pursue a dispute with the reporting entity directly or through the credit bureaus. For more information on disputing incorrect information on your credit report, visit the following topic page on the Consumer Financial Protection Bureau.

Credit Score

As noted above, your credit report is similar to the assignments you submit during your time as a student. After you’ve turned in your assignments, you receive a grade and subsequent GPA based on the work you produced. In the world of credit, your credit score represents the work you’ve done as a credit user. Essentially, your credit score is the grade you receive when your trustworthiness using credit is examined.

In the United States, there are two primary agencies behind credit scoring, each with their own respective score:

Vantage Score and FICO Score.

The FICO Score comes from the Fair Isaac Corporation,  a data analyst company, while the Vantage Score comes from collaborative information provided by the three credit bureaus.

Both scores range from 300-850, but each scoring model differs in what scores fall within the following ranges: Excellent, Very Good, Good, Fair, Poor, or Very Poor:

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 Other differences between the two scoring models include the impact of hard inquires on checks on your credit report when comparing rates, how collection accounts are reflected on your credit report, and the length of credit history needed to generate a score.

Want to learn more about the differences between FICO Scores and Vantage Scores? Visit the Equifax Knowledge Center!

Both FICO Scores and Vantage Scores use most of the same factors or criteria to determine the scores. The factors of a credit score both FICO and Vantage use are:

• Payment history
• Total debt amount (also called Credit Utilization)
• Length of credit history
• New credit accounts
• Different types of credit

Vantage Scoring also takes into consideration two other factors:

• Your recent credit behavior
• Your available credit

FICO Scoring assigns a certain weight or percentage for each factor of your creditworthiness and borrowing behavior:

• Payment History- 35%
• Credit Utilization- 30%
• Length of History- 15%
• New Credit Accounts- 10%
• Different Credit Types- 10%

Vantage Scores however, do not use percentages but rather assign a level of influence each factor has on your credit score:

• Payment History- Extremely influential
• Credit Utilization (percentage of your credit limits in use)- Highly influential
• Length of Credit History & Mix of Credit Accounts- Highly influential
• Amounts Owed- Moderately influential
• Recent Credit Behaviors- Less influential

As lenders, creditor, or other agencies review your scores, there are general ranges that typically result in greater chances of approval and more competitive interest rates:

• Excellent or Exceptional- Greatest chance of approval and most likely to obtain the lowest interest rates and fees
• Very Good- Very high chance of approval along with very competitive rates and terms
• Good- Generally deemed as an acceptable borrower and approval is likely but may receive higher rates and not as competitive terms; a majority of Americans fall within the “Good” range and
• Fair- Lower changes for approval; if approved rates and terms are among the least competitive
• Poor & Very Poor- Low to no chances of approval; if approved, would receive very high rates and other poor terms

Remember that these are general guidelines for approval. Each creditor and lender will have its own criteria for approval. Additionally, credit scores are typically just one of several factors that lenders will use to determine approval and the given terms and conditions you receive when borrowing or using credit.

 

When borrowing or utilizing credit, there are two types of credits that consumers may be using:

• Revolving Credit
• Installment Credit

Revolving Credit

Credit products that are considered Revolving Credit are credit cards. Once approved for a line of credit with a credit card, you have continuous use of that amount. As you pay off your balance on a month to month basis, your borrowing ability will reset accordingly and you can borrow up to that line of credit again and again for as long as keep that line of credit open.

Installment Credit

Credit products that are considered Installment Credit are traditional loans like Student Loans, Home Loans, and Auto Loans. These borrowing products allow you to use a lump sum of money in a singular event. Once you receive the borrowing amount, your lender has fulfilled their obligation and you are not entitled to any additional borrowing amounts. You are then responsible for paying the respective lender back in set payments over a period of time.

As you get ready to establish your own credit history, it’s important to know the options you have in getting started as a credit user.

Establishing Credit with a Credit Card

One of the most common ways to establish credit for the first time is by opening up a credit card. As explained in the Creating Your Money Management System topic page, credit cards allow users to borrow through a maximum line of credit. If what you have borrowed is paid back by its due date, which is reflected in your monthly statement balance, then you will not incur interest and will not have had to pay back anymore then what you used. Essentially, using a credit card becomes interest-free borrowing.

As someone without any prior credit, there are only a handful of credit cards that will meet your needs in establishing history for the first time. The two types of credit cards you will most likely need to consider are Secured Credit Cards and Student Credit Cards.

Secured Credit Cards

Upon approval, most credit cards users are given a specific line of credit to use that equates to the same monetary amount to spend. For example, if you have a credit card with a line of credit of $1,500, the most amount of money you can put on the credit card is $1,500. These types of credit cards are considered unsecured: your line of credit is not given to you based on collateral or any financial reassurance, simply on your past behavior as a credit user.

Secured credit cards however, require a user to deposit the amount of money they would like their line of credit to be with the creditor or bank that will be issuing the credit card. For example, if you wanted to open a secured credit card with a line of credit for $300, you would need to have $300 in hand that you then deposit with your creditor or bank. The $300 you deposited becomes the line of credit you have available to use on your credit card.

The type of collateral you are required to put up front with secured credit cards means you may be more likely to get approved as compared to the traditional process involved with unsecured credit cards- those with no previous credit history are considered quite risky to work with as there is no prior borrowing behavior to give creditors a sense of how trustworthy you are. The security behind the required deposit mitigates the perceived risk as your money is already deposited with them… if for some reason you didn’t pay back what you borrowed, the creditor or bank would only need to apply your deposit to the balance.

Moreover, after you have demonstrated trustworthy borrowing behavior through your secured credit card, typically 6 months to a year of using the card, many creditors and bankers will allow secured card users an opportunity to transition to an unsecured card, which may result in the return of your initial deposit and an increase in your credit limit.

 

Student Credit Cards

While secured credit cards can be a great option for those looking to establish their own credit history, the upfront collateral required to open this type of credit card can prove to be a significant barrier.

For students that are looking for an alternative to a secured credit card, a student-specific credit card may be an option to consider. Student credit cards are designed with college students in mind and usually have different requirements that make it easier to get approved. Generally, as long as you have a regular income stream established, such as through a work-study position or other part-time job, and have not had poor or bad credit history, you are likely to be approved. Student credit cards tend to have low spending limits, no fees, and may even include things like cash back bonuses for certain purchases.

 

Regardless of the credit card you decide to establish credit with, remember to only spend what you can afford- credit cards are notorious for having interest rates upwards of 15%... in some cases that could be triple the rate of your student loans! If you spend more than what you are able to pay back, credit cards can cost you hundreds of dollars in interest long term and have lasting impacts on your personal finances.

 

Establishing Credit with a Loan

For individuals who are not able to open a Secured Credit Card or who may not feel ready to use a credit card responsibly, credit can also be established by taking out a loan. As students, the loan most readily available to you is a student loan, specifically a federal student loan. As long as you are eligible to receive federal aid and have completed the FAFSA, the Free Application For Federal Student Aid, you have the option to utilize a federal student loan.

The Federal Direct Subsidized for undergraduates as well as the Federal Direct Unsubsidized Loan for both undergrads and graduate/professional students do not require credit checks or previous credit history as a means of approval, something that can prove to be a barrier when establishing credit for the first time. Moreover, the Direct Subsidized Loan does not accrue interest while you maintain your student status and until the loan goes into repayment, another added benefit for those who are concerned they may accidentally accrue interest while using a credit card.

Unfortunately, those who decide to establish credit through their Federal Direct Unsubsidized Loans will be accruing interest as part of the terms of the loan type. For those only looking to take out a loan for the sake of establishing credit, doing so through a student loan that accrues interest may not be the best option from a dollar per dollar perspective as there are other means to establishing and using credit that will not inherently cause you to pay interest.

To start demonstrating positive credit behavior and take your history further, establishing credit through a student loan will most likely require you to make payments toward the balance while in school due to two factors that have the most impact on your score in both the FICO and Vantage Scoring Models- Payment History and Total Debt/Amounts Owed.

Once you have established your own credit, there are several good practices to incorporate in your credit system:

• ALWAYS pay your credit cards bills and loan payments on time
• Avoid only paying the monthly minimum on credit cards- plan to pay your balance off in full every month (if you carry a balance you are likely to pay interest!)
• For any credit cards you hold, avoid balances that exceed 30% of your credit utilization or overall line of credit. Even though you are approved to spend up to your maximum line of credit, if you keep your balances below 30% of the line of credit, you can see significant increases in your credit score
  • Since there are no penalties for multiple payments towards you credit card, you can make payments as often as you need to avoid carrying balances that exceed 30% of your line of credit
• For loan borrowers, know what platforms are needed to manage and pay on your loan. For example, federal loan borrowers do not manage their loans on studentaid.gov, but rather through an assigned loan servicer
• Connect your checking account or banking information to your credit card and loan accounts for a streamline way to pay down your balances and submit your monthly payments
• Review your accounts often and keep an eye out for incorrect information or suspicious activity. In the days of digital finances, identity theft is a big concern.
• Know the terms and conditions you are agreeing to before securing any credit card or student loans. Incorrect assumptions regarding borrowing and using credit can be detrimental to your personal finances.

 

These practices can positively impact your credit score and increase the likelihood that you will be seen as a trustworthy credit user and borrower by lenders, creditors, and other financial institutions. Your reputation as a borrower as far reaching effects on many other aspects of your personal finances and financial well-being.