Updated: Mar 3, 2021
Let's talk credit. What it is, what affects it both good and bad and how it is beneficial to you for long term wealth.
We previously talked about credit cards and what to look for when getting them but let's take a step back and talk about credit!!!! EEEEKKKKK the dreaded credit conversation that most of didn't really have with our parents growing up and just kind of fell into as adults.
Credit refers to an agreement to purchase a good or service with the promise to pay for it later. It tells a lender how well you manage credit (borrowed money) and how you pay it back. Unless you rolling in dough and can make large purchases in cash, you need credit for just about everything.
There are 3 different types of credit:
Installment Credit - You borrow a specific amount of money from a lender and agree to pay it back in installments over a specified amount of time. These are typically mortgages, student loans, car loans. Don't forget the amount you borrow will be less than what you pay back because of interest.
Revolving Credit - A lender extends you credit up to a certain amount to use repeatedly with the promiser to pay it back with interest. I talk more about this in the post The Hype Around Credit Cards.
Open Credit - Open Credit has elements of Installment and Revolving credit. With this type of credit, the amount owed is usually different every pay cycle and the amount must be paid in full every month. Utilities and charge cards are examples of open credit.
Understanding the different types of credit will help you better understand what should be done to build that credit up and keep up. How you handle your credit directly affects your credit score, good or bad. Your credit worthiness is tied to your credit score. Credit scores can range from 300 to 850. This scoring model was created by FICO (Fair Issac Corporation). Yes lenders may use a their own scoring model but the FICO score is the most common.
Excellent: 800 to 850
Very Good: 749 to 799
Good: 670 to 739
Fair: 580 to 669
Poor: 300 to 579
Factors that affect your score
There are 5 main factors that affect your credit score (For FICO, other systems may have different numbers):
Payment History - Makes up 35% of your score.
Having a consistent history of paying on time affect your score a good way. All 3 types of credit affect your payment. So be on time!
Total Amounts Owed - Makes up 30% of your score.
Not only is this category about how much you owe, it's about how much you owe as a percentage of your available credit. If your available credit. For example, if you only have one credit card with a limit of $500 and you owe $450, your credit utilization is considered high thus bringing your score down. If stays this way your score will continue to be lower than it could be.
Length of Credit History - Makes up 15% of your score.
This one always gets everyone. The longer you have credit the better. If you have no credit or just got credit your score will be lower only because lenders don't know you credit worthiness. If you have no credit or limited credit, make sure to pay your bills on time everytime.
Types of Credit - Makes up 10% of your score.
This is only a small portion of your score, but creditors and lenders like to see a mix of installment, revolving and open credit in your history. Shows you can handle making payments and are more likely to give you a good rate.
New Credit - Makes up 10% of your score.
When you take on too much credit at one time, this can be a red flag. It could signify that you are having financial issues and may not be able to repay what you are borrowing.
There are 3 main credit bureaus that report you credit, Equifax, Transunion, and Experian. They gather information from various creditors and provide that information to the Consumer Reporting Agency. From there, your credit report is generated with all the details of your credit and what's affecting it. Each bureau will provide 1 free credit report a year for you to review. Reviewing this report quarterly SHOULD BE on your financial health check every year. Pull a different one every quarter. If there is anything on those reports that shouldn't be there, dispute it. Your credit history could cause you to have a higher interest rate than you should and checking it regularly will help combat that.
This post just touches the surface of what credit is and what affects your credit. But these things will get you thinking about the credit you have differently.
Recommendations for your credit:
Make a plan to combat the debt you have obtained so your credit bounces back.
Pay your bills on time. If you can't, call the company and ask for assistance. You can't do this every month but a lot of times they will help you.
Check your credit report at least quarterly for discrepancies.
Keep your card utilization low If you are maxing out every month and your debt to income ratio is high, your interest will be high, if you even get to borrow the money.
Only spend what you need and try to use cash.
Co-signing with someone WILL affect your credit! Be careful.
If you have children, teach them about credit now.