Credit is an important financial tool that facilitates the purchase of goods and services that otherwise may not be possible. Examples include using a credit card to make a large purchase, purchasing a car or home, financing a college education, or even covering the cost of an emergency. Additionally, your credit score is often viewed by prospective landlords, insurance companies and even potential employers to gain insight on your financial situation, including signs that may signal an increased risk for fraud or theft. That’s why understanding how credit works and ensuring your credit score remains in good standing is crucial to your financial well-being.
The Basics of Credit
Credit is the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future. When you make a purchase using credit you are essentially utilizing a loan. These loans come in various forms including credit cards, auto loans, mortgages, home equity loans and lines of credit, personal loans and lines of credit, and student loans.
When applying for credit, the lender will pull your credit report in order to review your credit score and determine your ability to repay the loan. A credit report is a document that lists what types of credit you use, the length of time your accounts have been open, and whether you’ve paid your bills on time. It also tells lenders how much credit you’ve used and whether you’re seeking new credit.
Your credit score is a three digit number that tells a lender how likely you are to pay your credit obligations as agreed. There are three main credit bureaus that create your credit score – Equifax, Experian and TransUnion. These agencies receive information from creditors, usually monthly, about whether you are making loan and credit card payments on time. They also collect information about bankruptcy filings, court-ordered judgements, tax liens, and other public information from courthouse records. They then create credit reports with the help of scoring models like VantageScore and FICO. The scores usually range from 300 to 850, with 300 considered poor credit and 850 considered excellent credit. Your credit score is determined by a variety of factors including:
- Total Debt Balance –How much do you currently owe across all of your credit/loan accounts?
- New Credit – Have you opened any new credit accounts lately?
- Length of Credit History – How long have you been using credit accounts?
- Credit Mix – What types of credit accounts do you currently have?
- Payment History – Have you paid all of your bills on time and in full?
In addition to reviewing your credit score and a report, a potential lender may also consider the following when reviewing a credit application:
- Character - Your credit history and score will portray how you have paid your bills or debts in the past.
- Collateral –Some lenders may require that a loan be backed up by the value of personal property, such as a house or car.
- Capacity - As borrower, you will be required to prove you have the financial means to repay the loan.
- Capital - A lender will look at your net worth. Net worth is the value of your assets (what you own) minus liabilities (how much you owe).
Managing and Improving Your Credit Score
Now that you have a basic understanding of what credit is and the factors that impact your credit score, following these simple tips could help you manage and even improve your credit score.
- Monitor your credit score – Managing or improving your credit starts with knowing where you stand. Therefore, it’s important to view your credit report at least once per year to take control of your financial future. Doing so also helps protect yourself against identity theft by providing you with the opportunity to potentially catch fraudulent or suspicious activity that may affect your score such as new and/or unpaid credit accounts that you didn’t open. Per the Fair Credit Reporting Act (FCRA), you may order one free copy of your report from each of the credit reporting companies (Equifax, Experian and TransUnion), at least once every 12 months. You can request these copies of your credit report each year by visiting annualcreditreport.com.
Many lenders also offer credit reporting services to their customers, free of charge. These services allow customers to view their credit score continuously throughout the year. For example, First National Bank of Omaha credit card holders can keep tabs on their FICO® credit score* monthly by logging in and viewing their credit score online 24/7.
- Pay any past due accounts: If any of your accounts are past due, meaning you are late in making your payments, be sure to pay them ASAP as they could drag your credit score down. Then be sure to make all payments on time going forward.
- Pay your monthly balance in full: It is usually in your best interest to pay off your credit balance each month in order to maintain or improve your credit score. If you are unable to pay off the entire balance, make your payment on time and try to pay more than the minimum payments to limit how much you pay in interest charges.
- Reduce your overall debt: When you don’t pay your balance in full each month, the amount left over is considered debt. Eliminating your debt is one of the most effective ways to maintain and/or improve your credit score. Pay off your account with the lowest balance first by paying at least the minimum payment each month plus any extra money that you can pay towards it. Once it is paid off, take the amount you were paying towards the first balance and start applying it toward the next highest balance. Keep doing this until all balances are paid in full. During this process, be mindful not to add additional debt to your other accounts and maintain at least minimum payments on every account. To calculate how much it will take to pay off what you owe, try using an online calculator.
- Do not cancel all existing credit lines: You benefit from a long credit history, which is why it is important not to cancel all existing credit lines, even after they have been paid off. Lenders also take a look at your credit utilization ratio which is the amount of revolving credit you're currently using divided by the total amount of revolving credit you have available. Closing a credit line could negatively impact that ratio, causing your credit score to drop.
- Do not needlessly apply for credit: It’s tempting to apply for every retail credit card available in order to take advantage of discounts on each purchase, but doing so can negatively impact your credit score. Not only could it increase your chances of overspending and accumulating debt, the applications for credit show up as inquires on your credit report. This is an indication to lenders that you may be taking on new debt and could reduce your chances of getting approved from something more important in the future like a home or auto loan.
When used correctly, credit can be a valuable tool in reaching your personal goals. Remember, your credit history reflects how you handled your financial obligations in the past. By making and implementing a plan, you could see an improvement in your credit score. At First National Bank, we are committed to helping you achieve your financial goals. A personal banker can sit down with you and help you understand your credit scores and provide insights on ways to improve it.