Sigma Pi Fraternity International

Credit 101: Frequently Asked Questions

Credit is probably one of the most important, least understood aspects of personal finance. Credit scoring affects every major purchase in your life, from cars to school to houses. Good credit opens doors, bad credit closes them. But what is credit, and why does it matter to you?

What is credit?

Fundamentally, credit is a record of how timely you are in paying back money you have borrowed. Your credit is stored as a report and a score at a credit bureau.

Where is credit used?

Credit scores are used by any organization that deals with the lending of money, from credit cards to colleges to realties. Companies that judge risk use your credit score, such as insurance agencies. Here is a short list of company types that are known to check your credit:

• Banks & credit unions
• Employers
• Cable & telephone service companies
• Insurance & HMOs
• Cellular and Internet service companies
• Mortgage, loan, and credit card companies
• Colleges and private schools
• Private student loans

Credit scores and reports even impact your employment - if your current or future job exposes you to the financial workings of the company, your employer may use your credit as a means of judging risk. Employees or candidates with poor credit may be judged to be high risks for embezzlement, and may be denied employment.

New for 2004 - 2005 : FICO credit score are now being used for insurance purposes! What does this mean for you? If your credit is less than good, your insurance costs are going to go up.

How is credit judged?

Credit scores are numerical indexes based on an algorithm developed by Fair Isaac Company, called a FICO score. Scores are negatively impacted by events such as late payment, incomplete or partial payments, defaults, and judgements or liens, and range from 300 to 900. The actual algorithm is a trade secret of Fair Isaac, but the following breakdown approximates the weighted values that compose your score.

• 35% Payment history
• 30% Outstanding debt
• 15% Length of your credit history
• 10% Recent inquiries on your credit report
• 10% Types of credit in use

The "average" credit score for "good" credit is 675 or better for most major lenders, such as mortgage lenders. Scores lower than 625 demand scrutiny, while scores lower than 600 will often be denied outright.

In addition to a credit score, up to four FICO "reason codes" may be included in your credit report. These reason codes explain why your credit request was approved or declined.

How do companies judge my credit?

Many companies have begun to institute automated loan decisioning, in which your credit score is requested from one or more credit bureaus and then matched against an arbitrary index. For example, a mortgage company may decide not to lend to any individual with a credit score less than 600. Other companies go one step further and assign levels of risk to lower scores; a borrower with a near-perfect score may receive a much lower interest rate on a loan or purchase than a borrower with a poor score. Still others may automatically decline an application if a certain FICO reason code is included in the report.

Below is a generalized average rating of FICO scores. Most lenders look for acceptable or better scores; each lender makes a decision about what level of risk they are willing to accept.

• Excellent ("Class A borrower"): over 720
• Acceptable ("Class B borrower"): 660 to 720
• Uncertain ("Class C borrower"): 620 to 660
• High risk ("Class D borrower"): less than 620

These scores plus the FICO reason codes form the basis for loan decisioning.

How can I maintain/improve my credit?

Step 1: Obtain your credit report.
Because scores are computed based on the information in your credit report, the first step is to obtain a copy of your credit report. If you have been declined for a loan or credit-based service, you are entitled to a free copy of your credit report; contact the declining lender for more information.

Otherwise, obtain a copy of your credit report for a nominal fee.

Step 2: Clean up your credit report.
Review your credit report for accuracy. Even in cases where information is accurate, you are permitted and encouraged to submit your own information to be appended to your credit report. For example, if you have missed a payment due to loss of a job, you can submit that information to be included when a lender requests your credit report.

Step 3: Review the FICO Score Breakdown.
We presented earlier the FICO score breakdown. Based on this, you can choose the strategy you want to use to improve your credit.

• 35% Payment history
• 30% Outstanding debt
• 15% Length of your credit history
• 10% Recent inquiries on your credit report
• 10% Types of credit in use

Payment history examines how you've made your payments. Did you make payments on time and in full? If you have late payments, how late are they?

Outstanding debt examines how much you've borrowed, both in dollar amount and in perecentage of available credit. For example, a credit card with a $15,000 limit that is charged to $14,998 (99% debt load) is penalized more heavily than two credit cards with $15,000 limits that are charged $7,449 each (49% debt load each).

Length of credit history examines how long you have been a borrower. There are some lending institutions that will not lend to persons with short or no credit histories.

Recent inquiries on your credit report tracks how many institutions have inquired about your credit. A large volume of inquiries, especially from similar institutions (such as mortgage brokers) may indicate a significant need for credit and is considered negative.

Types of credit in use looks at how many forms of credit you have. Positives include a variety of credit types with little repetition, such as a mortgage, auto loan, credit card, etc. Negatives would be a series of credit cards or home equity loans. The more diverse and non-repetitive your credit is, the better your score.

Step 4: Cease adding new debt.
While this may seem overly obvious, it's not easy to implement. Put together a monthly budget on a simple spreadsheet and determine how much you are spending. Adjust your spending habits so that your income always exceeds your expenses by at least 10%, or the minimum monthly payment on your largest debt, whichever is larger.

Step 5: Turn over a new leaf.
Given that 65% of your FICO score is based on outstanding debt and payment history, the next most obvious step is to reduce one of the two. You cannot change your past history, unfortunately, beyond adding your own documentation and comments to your record. Only time can change that first 35% as you develop a successful credit history. Your credit history is a moving target - each new day adds a new entry to your record and drops a day off the tail end of your history. That brings us to the next point:

Make a commitment to yourself: pay your bills with the minimum requried payment or better when due.

Nothing will help you improve your credit faster than simply making the required payments to your creditors when due.

Step 6: Reduce your debt load.
The next 30% of your credit score is how much debt you have. Personal finance advocates will rightly suggest that you pay off your bills as quickly as possible, starting with the loans that have the highest interest rates first. Doing so is sound fiscal policy.

However, recall that you are also penalized for loans which you have nearly reached or reached the credit limit. Make a best effort to reduce your debt load on these loans to 75% or less of the total available credit.

If your goal is overall financial health, devote your attention to the highest interest rate loans first. Refinance them if you can, otherwise pay them down.

If your goal is primarily improved credit, reduce your debt loads on maxed-out loans first, then focus on interest rates once your debt loads fall below 75%.

Step 7: Consolidate your debts.
Recall that the number of loans and types also matters - 10% of your credit score. Consolidate as many of your debts as you can. Use Student Loan Consolidation to reduce the number of student loans you have outstanding. Avail yourself of credit card consolidation services when it makes sense to do so. If you have mortgages and home equities, consider refinancing to lock in a historically low interest rate and reduce the number of total loans.

Sigma Pi would like to thank Credit Cards Magzine who provided the information used in the creation of this webpage.