Is the Credit Rating System Fair?

The main reason that the credit rating system is fair is because each person controls his/her own credit rating. Your borrowing and payment habits are what dictate your credit rating. If you abuse your credit, your credit rating reflects the same. However, if you are a responsible credit user, your credit rating will be favorable.

Lenders need a system that can help them determine whether a person is a borrowing risk. By using the current credit rating system, lenders have some kind of barometer for measuring credit risk. Without such a system, obtaining a loan would be extremely difficult because lenders would require, among other things, years of financial records to help determine the potential borrower's creditworthiness. Our current credit rating system conveniently compiles all of a person's financial records and uses them to create a nice, neat number that lenders use to make lending decisions.

The people that complain most about our credit rating system are the people that have low credit scores. These people claim that their low credit scores are somehow not their fault. These people claim that the credit card companies kept sending them more and more credit, and that they just "had" to use this additional credit. Are these people serious? We reap what we sow. It is amazing to me that a person can abuse their credit privileges, and then complain about the penalties that are assessed as a result of their abuse. These complainers are proof that the system is fair and is effectively working. If the credit rating system was unfair, these credit abusers could continue to take advantage of their credit privileges to the detriment of responsible credit users.

Another common complaint that people make is that they have no credit score before they apply for credit. The argument that these people make is that they have never had debt, therefore, they should have a high credit score. How does this make sense? A credit score measures a person's creditworthiness. Therefore, how can one have a credit score without first having credit? This is not a hard concept to understand.

The system is not perfect, but it is fair. I have had my credit score reduced due to negative information being placed in my credit file that was not mine. I had to get the information removed by contacting the credit bureaus. I would be lying if I said that the information was immediately removed. In fact, it took a couple of months to get the information removed. I was not happy, but mistakes happen. If the system was perfect, there would be no complaints.

The point is, the system is as fair as it can be. If you feel that the credit rating system is unfair or unreliable, pay cash for everything. If you cannot afford to pay cash for everything, stop complaining about the system and use the system to your advantage. If you use your credit responsibly, you will have nothing to worry about.


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Credit Score Conundrums

In my previous post, What are the Components of a FICO Score?, I discussed what the Fair Isaac Corporation takes into account, and each items respective weight, when calculating your FICO score. The interesting thing that I have noticed is that certain practices can both raise and lower your credit score. Lets look at a few of them:

(1) 30% of your score is based upon you debt to credit ratio, while 10% of your score is based upon the number of credit inquiries and “new” credit. The ideal situation is having a maximum of 25% of your credit in use as compared to your debt. Therefore, if you have $1000 in credit, you want to owe no more than $250 total.

As you continue to make consistent payments on your cards, you will most likely become eligible for a credit limit increase. However, you usually have to ask the credit granting company for an increase on your limit. This is good because it will lower your debt to credit ratio, however, you have just created “new” credit and just had an inquiry dinged against your credit report, and thus could lower your score. Interesting!

(2) Some experts state that you should pay off your outstanding balance in full while other experts say that creditors want to see consistent payments, thus you should always pay your bill over time. We now know that 35% of your FICO score depends upon timely payments. Nowhere in that calculation does the amount paid come into affect. Creditors send you a bill with the minimum payment set for you. Most experts agree that you should more than the minimum payment, but not for credit score reasons. You should make more than minimum payments so that you do not get hosed by the interest charges.

The bottom line is, paying off your amount due, whether in full or in parts, is not going to hurt your score (as long as those payments are timely). If you can afford to pay more than the minimum payment, do it. If you cannot, do not. I seriously doubt a creditor is going to penalize you (by means of a lower credit score) for paying back their money in one lump sum!

(3) 10% of your score is based on the type of credit you have. Most people build their credit score in order to take out installment loans, however, installment loans can lower your score. The situation that presents itself is an odd one. Most people build their credit score in order to purchase a car and/or home. However, taking out one of these loans can lower your score because some creditors may feel that this big monthly obligation could affect your ability to pay them back. Now we are back to the debt to credit ratio and the choice of whether or not to raise the credit limits.

The truth is, it seems that certain simple strategies (pay your bills on time, keep your debt low, and keep your credit high) have been to proven to build a credit score significantly. All of the other little things can either slightly chip away or slightly add to your credit score. As I pointed out, some strategies can have both a positive and negative effect. Therefore, if you want to play it safe, stick to the simple strategies and always be aware of the contents of your credit report and credit score.

How Important is Good Credit?

Do you think that good credit is not an important asset? I have a friend that thought that very thing. Suddenly, not to long ago, reality slapped him in the face. His credit score was so bad that he could not get financed for a car! His lease was up and he tried to get another car, unfortunately, he was denied at every place he attempted.

You may be thinking that he did not look hard enough or was trying to get too expensive of a car. You may be correct, however, the point is that something like buying a car should be an enjoyable experience. Buying a car should not be an industrial pain that consumes one week of your life!

The sad truth about credit is that good credit is hard to get and bad credit is easy to get. If you have bad credit, you need to start today if you want to fix it. If you look at your credit report, you will see that negative information (such as late payments, charge-offs, etc) can stay on your credit report for years!

My buddy could not get financing for a $25,000 car. Could you imagine if he tried to get financed for a big purchase, like a house? That is too scary for me to imagine! Take care of your credit and you will be one step closer to financial freedom.

Tips to Raise Your Credit Score

In my previous post What are the Components of a FICO score?, I discussed the different components of a FICO score and their respective weights in determining your credit score.

This post will provide a few tips that you can use to raise your credit score. First, if you have no idea what your credit score is or what information is in your credit report, I suggest you get both. You can get a free copy of your credit report from all three credit reporting agencies by going to Annual Credit Report. This service is completely free (there is absolutely no catch) and is easy to use.

Your credit score is a different story. I am unaware of any website or company (except Washington Mutual that just started the promotion of giving you access to your credit score for free if you have one of its credit cards) that will give you free access to your credit score. If you really want to know your credit score and do not want to pay for it, there is a free way to obtain the information, although it is a little shady.

If you want to get a free look at your credit score, go car shopping! Better yet, just call a car dealership and tell them you are interested in a car. They will run your credit to see if you qualify for the car you are “interested” in. Once they say you qualify or not, ask the salesperson what you credit score is. They will almost always tell you. When the salesperson wants to move on with the deal, just tell them that you are doing some comparative shopping and price searching and that you will get back to them.

If you are uncomfortable with obtaining your credit score this way, all three of the credit reporting agencies will let you buy the information for around $15.00 for all three scores.

Once you have your credit scores and reports, you can see where you need improvement. There are some general things you can do to start to boost your score. Although you will no longer be able to use the authorized user method to boost your score, you can still, (1) pay bills on time; (2) keep your debt low; and (3) not open lots of accounts at once.

Those are general tips, but there are other things you can do and other information you should know.

(1) If you can prevent it, do not close credit accounts. Many people close credit accounts they hardly use or that they just paid off to avoid the temptation of using the card again. This is a bad move because 15% of your credit score is based upon the length of your credit history. If you find that one of your cards is not in use, start using it for a very specific thing (for example, only buy gasoline/diesel with that one card) and use it for nothing else. By doing this, the card is in use, and the payment will be low. This way, you get to keep your lengthy credit history, and you are building points by making your payments on time.

(2) Closing an account does not mean that you no loner have to pay what is owed. This seems simple enough, but you would be surprised how many people are under the false impression that closing a credit account means that they are no longer liable for the debt. This is a rookie move and should not be made by aspiring entrepreneurs! Do not close the account because you are having trouble paying, instead, stop using the credit card! None of the fees change and none of interest rates decrease by closing the account. Therefore, what is the benefit of closing the account? If you fear that by keeping the account open you will continue to use the card, destroy the card. Later, when you feel you have gotten things back in order, call the credit company and tell them that your card was destroyed (by the washing machine, the dryer, or whatever you can think of), and get a new card. By closing the account, you only hurt your lengthy credit history!

(3) Know that certain debts are weighed differently than others. Revolving debt is weighed more heavily in determining your creditworthiness. Revolving debt is money owed to a creditor who sets your monthly payment based on the current balance. This is different from installment loans, (such as student loans) where the amount owed is fixed (not based on your current balance), usually payable monthly, and almost never changes. Keep those revolving debts low and your score could increase.

(4) If you have bad credit and are having trouble getting a card, try a department store. If you find yourself having trouble getting credit from the “big boys” (Visa, MasterCard, Discover, American Express, etc.) try getting a card from a department store. Their interest rates are terrible, but they are usually much easier to get. This credit will help you start to reestablish yourself as creditworthy and will help improve your score, if you make timely monthly payments and keep the debt low.

(5) If department stores do not work, you can get a secured credit card. Secured credit cards are credit cards with a deposit backing. In other words, your credit limit is set by how much money you give the company. If you deposit three hundred dollars, your credit limit is three hundred dollars. Unlike a debit card though, charges do not come out of that deposit amount. You are sent a bill like a credit card and have to make the payments. Be cautious if you take this route because some of these companies are predatory and charge OUTRAGEOUS fees and interest rates! If you find out that you are paying more to possess the card they you are actually spending by using the card, dump it!

What are the Components of a FICO Score?

The Fair Isaac Corporation is the company the created the FICO score for credit. A credit score can range between 300-850. All three of the credit reporting bureaus (TransUnion, Equifax, and Experian) use a FICO score system, except each bureau calls their respective systems by a different name. TransUnion has EMPIRICA, Experian has the Experian/Fair Isaac Risk Model, and Equifax has BEACON. Do not be confused by these names. Although different by name, these credit bureaus’ systems differ only slightly in calculation.

Although the exact formula used to calculate a FICO score is unknown to the general public, the Fair Isaac Corporation has released the components used to calculate a score and their respective weight in the calculation.

35% of your score is based upon your Payment History. Late payments of all types are reported in your credit report. People are sometimes under the misconception that as long as they pay their credit cards on time, it does not matter if anything else (like your car payment, your cell phone, doctor bills, etc.) is late. This is far from true. Any late payment to a creditor can be reported in your credit report by way of collections, lawsuit, wage garnishment, attachments, lien, and judgments, to name a few.

30% of your score is based upon your Amounts Owed. This is called a debt to available credit ratio. Basically, if you have two credit cards with a $2,500 limit on each, your total available credit is $5,000. If these accounts are “maxed out” then this will lower your score. As a good rule of thumb, you generally want to have a total of only 30% of your total credit in use. Therefore, in this example, if you owe $1,500, you should be okay. Anything more, and you may be at risk of lowering your score.

15% of your score is based upon the Length of Your Credit History. This makes sense if you think about it. If you just got a credit card, there is no accurate way to gauge your creditworthiness. The longer you have credit, the more accurately lenders can determine the risk of lending you money. This equates into a higher score for you.

10% of your score is based upon New Credit. This does not mean that you should not open up any new credit cards. If you want more credit, do so sparingly. If you try to open and/or apply for a lot of credit at one time, it looks like you are in financial trouble or that you are going to be amassing a large amount of debt. Either way, it does not look good to lenders and can negatively affect your score.

10% of your score is based upon the Type of Credit in Use. Also referred to as a “mix,” this component looks to all the types of credit you have. Whether it is revolving, installment, mortgages, etc., a healthy mix will raise you score, although by very little. This component really only comes into play if you do not have many revolving accounts.

Do You Know What Is In Your Credit Report?

Many Americans would be amazed as to what they find in their credit report. I have had to deal with errors in my credit report for a long time now. My problems arise because I am named after my father. You would think that in this day and age, and with the many technological advancements that exist due to computers, distinguishing between two different people would be easy. Apparently, this concept eludes the credit reporting bureaus.

Due to the fact that my father’s accounts appear on my credit report and vice versa, I constantly have to contact the three bureaus and the reporting banks. It really is a nightmare! I have to do this because two things are happening when the bureaus and the banks incorrectly report accounts in my credit report. First, I lose confidence in the credit reporting system and the bank that incorrectly reports. Second, my father loses the benefits of having his accounts in his reports and my debt to available credit ratio changes, which could lower my score.

As you may know, Congress has changed many laws regarding credit reporting in order to benefit the consumer. If you go to www.annualcreditreport.com, you will get a free copy of your credit report from all three reporting companies. These reports are 100% free, meaning you do not have to sign up for some 30-day credit monitoring service. In is important to note that you can only get one free copy of your credit report from the three bureaus only ONCE per year!

If you share your name with somebody in your family, it would be a good idea to check your credit report. Keep in mind that you will not get access to your credit scores, but you will see if any negative information appears on your credit report.