Understanding Credit

By Daniel Duffield

What is Credit? 

Credit is the numerical representation of the risk which a particular borrower presents to a lender, determined by the assessed likelihood that the borrower will both be able to secure the funds necessary to pay back a loan and have the responsibility to do so on time. In other words, credit scoring gives lenders an estimation of how probable a borrower will pay off a loan on time. Credit ratings range from 350 for high risk borrowers to 950 for low risk borrowers, though few scores ever reach these extremes. Although several different types of credit scoring exist, most lenders solely use scores developed by Fair Isaac & Company, Inc., better known as FICO scores.

What does credit consist of?

Credit scores only take into consideration information presented within a borrower’s credit profile. While credit ratings do not take into account demographic factors such as gender, race, nationality, or marital status, they also do not consider other information that may be pertinent to lenders such as income, savings, or down payment amount. Rather, credit scores solely concern past delinquencies, irregular payment behavior, debt level at present, length of credit history, types of credit lines, and number of credit inquiries. As expected, credit scores regard both positive and negative information contained within a credit report. While late payments will negatively impact a borrower’s credit, he or she may raise the credit score by starting or restarting a consistent payment record. Each aspect of a credit score weighs differently against the others, divided into percentages as follows:

• 35% - Payment history
• 30% - Current amount of debt
• 15% - Length of credit history
• 15% - Types of available credit
• 10% - New credit inquiries

What is bad credit?

A person with bad credit is one that has been extended credit in the past, but who has been unable to repay their loans, or keep up with their other financial obligations, (such as utility bills or parking tickets). Because their history indicates to lending institutions that it may be risky to loan money to them, often times individuals with bad credit are only able to obtain loans with high interest rates or unattractive terms. Bad credit can be repaired over time, if the individual re-establishes a consistent and positive payment history on their financial obligations.

What is good credit?

In order to achieve “good” credit, borrowers must not only be able to successfully manage all lines of credit and make consistent and timely payments, but must also have sufficient financial obligations to necessitate these practices. In other words, you cannot have a good credit score if you do not have any credit, meaning that all high credit scores must be built as the result of diligent payments and smart financial management. Thus, borrowers must apply for credit via credit cards, vehicle loans, or home mortgage loans. After being granted credit, borrowers will establish a credit limit, or the maximum amount of credit available to a particular borrower. As a borrower proves himself or herself responsible in managing loan funds by making payments on time and keeping credit card balances paid off, the credit limit increases. Though the credit limit will initially be quite small and larger credit transactions (such as home loans) will be difficult to acquire, over time the limit will grow and allow borrowers to make larger credit purchases.

What is required to establish credit?

In order to establish credit, a borrower must have at least one account on his or her credit report open for six months or more. In addition, at least one account must be updated within six months prior to receiving a credit score. This information is necessary to establish a reliable reputation and to accordingly produce an accurate credit score. Borrowers who do not satisfy these criteria will need to begin to establish a credit history before planning to apply for a home mortgage.

How can I achieve a good credit score?

As previously indicated, making on time payments is critical in obtaining a good credit score. Regardless of the amount of debt owed, a borrower’s credit will suffer for each late payment, and frequent delinquencies will take much more time to recover from. Additionally, keeping credit card balances to a minimum of 30% of the card’s maximum limit can vastly improve your credit. Furthermore, it is advisable not to close unused credit cards when attempting to improve your credit score, since these may actually strengthen credit scores with even infrequent use by extending your credit history.
For more tips to improve your credit score, read our Lender411 Featured Article Invaluable Tips to Improve your Credit Rating.

Will checking my credit score lower my credit rating?

Due to recent policy changes, the negative repercussions associated with credit checks have been significantly diminished. Consumer initiated credit inquiries for mortgage or auto loans are discarded for scoring purposes for a full 30 days, after which multiple inquiries begin to accumulate as negative points. While all credit checks will appear on any give borrower’s credit report, only repeated inquiries over a prolonged amount of time will have detrimental effects to credit.

Other Factors

Credit scores are always accompanied by a maximum of four reason codes. These codes help to explain the logic behind a borrower’s score by specifying the reasons in which a particular borrower did not receive a higher score. Reason codes also assist lenders in outlining the reasons why a borrower did not qualify for either a loan or low interest rates. Although these scores involve credit history, reason scores are no included by the Fair Credit Reporting Act and are not part of a borrower’s credit profile.

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