When you’re thinking of buying your first home, one of the most common things you’ll be told to be aware of is your credit score. This will impact your ability to get a mortgage and ultimately impact how much you end up paying for your loan. A difference of a few percentage points on your interest rate can mean thousands of dollars either added or subtracted to the cost of your loan, and your credit score largely determines this.
Most prospective buyers are aware of this in principle, but how much do you really know about the mechanics of credit in practice and what impacts your credit score?
First of all, what is credit?
Credit is one of those things that everyone tends to understand, but we don’t often think of its actual definition. Credit is a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some date in the future, generally with interest. In other words, if your friend loans you fifty dollars to be repaid in two weeks with 10% interest – for a total of $55 – then they are extending you credit. Credit cards, auto loans, and mortgages all work the same way.
You’ll frequently hear “credit” as something you have, even when you don’t actually have an active debt or loan. What this means is your ability, or potential, to obtain credit. You can also think of it as credibility; if you have no credibility as, say, a scientist, then people are less likely to take you at your word when you present a claim. Credit works the same way, and it indicates your history of paying back any loans you may have had in the past. If you have no credit, or bad credit because you didn’t pay back earlier obligations, then everyone from friends to financial institutions might be less likely to loan you money because they can’t be sure that you’ll pay them back.
This is called “creditworthiness.”
Again, having credit is often a measure of your creditworthiness, or the level of risk a lender assumes by loaning you money. Your creditworthiness is determined by your history as a borrower. In other words, if you have a history of paying back your debts on time, then it can be assumed by a lender that you’re not a high-risk borrower, and they’re both more likely to lend to you and do so at a lower interest rate.
If you have a poor history of making payments on time, then you’re assumed to be a higher risk for a lender to take on, and they may either decline to extend credit to you, or do so at a higher interest rate to protect their balance sheet.
Your creditworthiness is measured by your credit score, which is a three-digit number that comprehensively sums up your credit history.
Your creditworthiness is defined by your credit score and this is the key to your financial life. A good credit score is often the crucial detail that makes all the difference when it comes to obtaining a mortgage or loan. On the other hand, a bad credit score will make it more difficult for you to get credit, and it will make it more expensive to borrow money.
While a good credit score is an important factor in obtaining any type of credit, many lenders are still willing to give loans to individuals with poor credit. If your credit is damaged, you will have to provide more documentation for your loan. It is also a near certainty that you’ll have to pay a higher interest rate as well. This is how financial institutions outweigh the risk of giving you money.
So who keeps track of all this? Who and what determines your credit score?
Credit bureaus, or as credit reporting agencies, are almost like a governing body when it comes to credit scores. The Big Three that are used by the majority of financial institutions and businesses are Equifax, Experian, and TransUnion. Credit bureaus collect the input data that feeds into credit score calculations, and this is made up of reporting by lenders and businesses.
The relationship between lenders and credit bureaus is a two-way street: lenders report data to the bureaus that is calculated into consumers’ credit scores, and the bureaus calculate those scores for lenders to access when a consumer applies for credit. Any lender with whom you have a loan or line of credit is going to report relevant data about you to credit bureaus. This includes details like the balance of the account, amount due, amount paid, and the status of the account (whether payments are current or past due).
Each time you apply for credit and a financial institution requests your credit report from a credit bureau, the application appears on your credit report and it will be factored in to your credit score. This even includes that Macy’s credit card you want to apply for in order to get a 10% discount on your purchase that day. These are known as “hard” inquiries, in which a lender requests your report because you applied for credit. Too many hard inquiries in a short amount of time can negatively affect your credit score, so you want to be judicious and responsible about applying for credit.
In other words, the very entities that decide whether or not to extend credit to you based on your credit score also play a big role in creating that credit score based on the information they report. This is, in a nutshell, why it’s important to pay your bills on time and build good credit.
You also want to make sure you pay your bills on time. Generally speaking, your utility company doesn’t regularly report to credit bureaus, but multiple missed payments can eventually appear on your credit report in other ways. Things like collections, bankruptcies or foreclosures are all reported to the credit bureaus and they can have a huge negative impact on your score.
So how and why should you maintain good credit?
Credit is one of those things that you actually have to use in order to obtain. If that sounds contradictory, remember that if you have no credit history, how is a lender supposed to assess your level of risk? When you begin your financial life, start small. Built credit slowly, and be responsible about it. This pays huge dividends when you need credit for large purchases, such as a house or a car, and a history of responsible use of credit can save you thousands of dollars.
Establish a good history of making payments on time and avoiding any defaults or collections. Your credit score is essentially your reputation. You can think of it as an adult report card that details how responsible you are with finances, and lenders will look at it to determine whether or not you’re a good investment.
But it’s not just consumer lenders that will check your credit score. If you start a business and need a line of credit, a lender will look at your credit score to determine whether or not to extend the loan (mostly because your new business has no credit when it begins). Most employers will also check your credit score these days because, in the same way that it provides an accurate barometer for your financial discipline, it can indicate how responsible and deadline-oriented you are as a member of their team or workforce. A good credit score goes a long way in this regard.
Landlords may also check your credit score. A poor score can effectively lock you out of nicer apartments or rental homes even if you can afford them, because again, your credit score is a measure of your reputation to someone who doesn’t know you but with whom you will have a financial relationship.
To sum all of this up, you have every incentive to keep your credit score high. Not only does it make borrowing money cheaper and more efficient, it can also affect your employment prospects and living arrangements. It’s not terribly hard to do, either; all you need is to employ responsible financial practices and be disciplined in your financial life. Don’t use credit frivolously; don’t borrow more than you can afford; make payments on time. If you have a subpar credit score, you can work towards repairing it by making house and car payments on time, paying off loans before the end of the loan period, and paying off your credit card in full each month.
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