Your Credit and You: Basic Information
Credit cards, credit scores, and credit reports are one of the most-discussed topics in
/r/personalfinance. The following is a summary of the basics you need to know about credit and how you should use it. I also address some common questions about credit cards. If you see something that isn't correct or have suggestions on other things to add, please let me know in the comments or by private message. This post does not presume to be "definitive" - you could write volumes on the intricacies of the credit system.
tl;dr please.
Never carry a balance on a credit card past your statement due date. Pay off your balance in full, every month by the statement due date. Do not take out loans you don't need for the sake of improving your credit score, and do not carry a balance because you think you need to in order to improve your credit score.
What is a credit score? How does it affect me?
Your credit score is an aggregate of a number of different factors that, when put through an algorithm, spit out a number that indicates how suitable you are to extend a loan to. People with good credit scores get the most competitive interest rates on mortgages, auto loans, personal loans, etc. The lower the interest rate, the less money the loan will cost you. Credit scores are also used as a factor in determining one's suitability for renting a place to live or for employment. While there are a number of different entities that calculate your credit score, the most prevalent is the
FICO score. This post is oriented towards the FICO score, but the general principals are applicable to most other credit scoring systems as well.
What's the best way to get a good credit score?
The single most important factor in any credit score is a history of on-time payments. Note that "on-time" does not necessarily mean "in full" - you are expected to pay the amount due each billing period based on whatever payment plan you are on. The monthly billing cycle is certainly one of the most common. The best way to improve your credit score is therefore to ensure that you are meeting the minimum payments on all of your debts.
The second important factor is total amount owed across all of your lines of credit. This is commonly referred to a utilization ratio. In general, a lower utilization ratio is better for your credit score's health. Utilization has no history, however, so only the last month's balance on your credit card (for example) is used in the calculation. The other factors that go into a FICO score are length of credit history, types of credit (credit diversity), and how many "new accounts" you have.
How does XYZ affect my credit score?
- Opening new credit cards/applying for new lines of credit - Applying for new credit cards requires a "hard inquiry" into your credit score - that is, a third party accesses your credit score to see if you meet their standards. This hard inquiry results in a small hit to your credit score. If you apply for a number of new lines of credit in a short period of time, these hard inquiries can cause a greater hit to your score. If you are approved for all of the lines of credit you apply for, that can count against you in the "New accounts" and "Length of credit history" categories. If you are looking to take out a large loan in the near term (mortgage, auto loan) you should not be looking to open new lines of credit. Your score will not have time to recover from the effect of the hard inquiries.
- Paying down the balance on a credit card before the statement due date - Paying down your balance early lowers your utilization ratio, as the balance on the statement date is the balance used for utilization purposes.
- Carrying a balance/stretching out a loan for the sake of credit - You should not carry a balance on a credit card to improve your credit score, nor should you stretch out a high interest loan for the sake of improving your credit score. The reason is that this costs you money. You do not need to pay a cent of interest in order to improve your credit score, so pay down those high interest loans as fast as you can.
What is a credit report? How do I get mine?
Your credit report lists all of your credit accounts, credit inquiries within the last two years, and public debt information. You can access your credit report once per year from each of the three major bureaus (Equifax, Experian, and TransUnion) at
annualcreditreport.com. It is a very good idea to check one of your reports every 4 months to ensure that no lines of credit are being opened in your name without you knowing about it.
Some credit monitoring sites such as
CreditKarma provide a continuously accessible credit report and a simulated credit score. Simulators like CreditKarma are useful for a ballpark estimate of one's credit score, as long as you appreciate that it is not an official FICO score. Anecdotal reporting by
/r/personalfinance redditors who have compared their CreditKarma score to their actual FICO scores indicate that CK is usually accurate within 30 points or so.
Why should I care about my credit score?
If you plan on paying for all of your major purchases in cash, it is true that you do not need to care about your credit score. However, most people don't have the means to make large purchases (houses or cars, for example) in cash. A good credit score lowers the cost of borrowing money for such purchases, leaving you with more money in your pocket after the loan is paid off.
In addition to making you more attractive to potential creditors, landlords, or employers,
/u/badgertheshit adds that a high credit score can often give discounts for things such as car insurance. The specifics will depend on your insurer.
/u/JonCheddar notes that a higher credit score also gives you access to the best rewards cards which, if used correctly in the manner described below, basically pay you to spend money you were going to spend anyway.
How do credit cards work?
Credit cards are far and away the most widespread form of consumer credit in the U.S. A credit card has a dollar limit per account, up to which the cardholder and their authorized users are allowed to spend before being cut off. The card issuer is extending an unsecured (i.e. no collateral) loan up to the amount of the card limit for a period of one month.
Every month the card issuer sends the cardholder a statement, indicating how much money the cardholder has borrowed during that month. The cardholder typically has about a month to pay the balance before interest is assessed on any remaining balance. Each statement balance typically has a minimum payment - if the cardholder makes the minimum payment it does not affect the payment history portion of their credit score. However, interest rates on credit cards tend to be quite high, so card issuers intentionally make the minimum payment low (1% of the balance due is not uncommon) to incentivize people to make the minimum payment to avoid getting a late hit on their credit report but to maximize the balance on which they can charge interest. Credit card debt is therefore highly destructive to one's financial health due to the high interest rates. If you are carrying a balance on your credit card, that is a strong indication that you cannot afford whatever you are charging to it.
/u/aceshighsays notes that one strategy to avoid a late payment on your bill is to set up automatic bill pay. If you do this, it's still a good idea to check your statement monthly for any discrepancies and your bank account before the automatic debit to ensure you don't get into an overdraft situation. You should make sure that you set the automatic payment to pay your statement balance, not the minimum payment.
I have no credit history. How can I start?
One of the most common ways to start building your credit history is to get a secured card.
Nerdwallet is an excellent resource to compare secured cards and find one that is good for your situation. A secured credit card is backed by collateral - specifically cash in the amount of the card's "credit" limit. A secured card with a $500 limit requires $500 in collateral from you.
Once you get your secured card, start building your history of on time, in full payments. A lot of secured cards allow upgrades to unsecured cards after a certain amount of time provided you've shown you can handle the card responsibly. This can range from 6 months to two years.
