Know your Credit Score

Bills, bills, bills...

Imagine for a second it's 6:30 PM on a Friday, you've just finished work and rush hour traffic is bumper to bumper. You are late and you've got 30 minutes left to pay your utility bill before the Department of Water and Power closes. If you don't get there in time, it's lights out at your apartment until Monday. You're still 15 miles away and unfortunately, not going to make it.

One alternative is to use your credit or debit card to make the payment. However The Department of Water and Power will not accept payment on credit from you. You bounced a check once and now must pay with cash only. You have no credibility.

This is the scenario I found myself in when I was younger. It was awful; I had to sit through a weekend in total darkness and missed the Evander Holyfield, Mike Tyson knock out. Everyone else saw it but me. Let my experience be a lesson to you. Mess up your credit when you're young and you could face a financial knock out for life.

Why is a good credit score so important?

If you're a multi-millionaire baller that can pay cash for anything, then you don't really care what your credit score is. As a matter of fact, being rich and having poor credit is not necessarily a contradiction; not all rich people honor their bills, let alone on time.

But for us normal middle class folks that aren't financially independent, having a decent credit history and as high a score as possible is important for stuff like:

• Purchasing or leasing big-ticket items. Lenders determine your eligibility for a car loan or lease, or a home mortgage. The lower your score, the higher the interest rate... if you are not denied for having too poor a credit score!
• Renting an apartment. Landlords enjoy collecting rent on time and therefore shuffle through credit histories to evaluate a potential tenant's trustworthiness.
• Getting a job. Most employers want reliable associates; therefore a lot of them not only perform background checks but also look into credit histories before hiring.

 

The concept of credit

Let's start with the general idea of credit before dealing with technicalities. There is a line in the movie Scarface where Tony Montana says something like, "All I got is my word... and I don't break it for nobody." In a nut shell, credit, also known as your good name, historically stems from human judgment. Tony was saying his word meant everything to him; that it was unbreakable and could be depended on no matter what.

Being granted credit depends on your reputation as a borrower. It's based on your history of borrowing money and capacity of reliably paying it back. This money could come from banking institutions to purchase a home for example, or borrowing from government agencies like Sallie Mae for a college loan, or just maybe from your best friend who loans you enough to help pay a bill. Credit is borrowed money that you can use to purchase things you want, and then repay the funds back at an agreed upon time.

History and evolution of the concept

In the history of human trade, credit has always accompanied commerce. Without it, no business transaction could ever be completed. In past times for instance, a wealthy countryman granted money to a poorer farmer to give him the necessary leverage to acquire more land. As a result the poorer farmer could exploit the land and increase his production right away, rather than working and saving for decades before being able to purchase it on his own. The wealthy countryman knew the farmer by his reputation - a local hard working man praised by his peers for honoring smaller debts in the past. So both men met and the deal was sealed with a handshake. From then on, every other week, the countryman visited the farmer and collected interest on the loan in the form of food, livestock or services, until the debt was paid back in full by the farmer. Had the farmer defaulted on previous loans the countryman would have refused to lend him anything. Had he merely not been as reputable, the countryman would have asked for more interest in return for the loan the farmer was seeking.

Of course providing credit on gut feelings proved inefficient, unreliable and often unfair. So lenders searched for more systematic criterions and began to standardize ways to profile consumers' spending habits. At the beginning, banks used profiling methods that were quite empiric and did not rely on sufficient information to be completely satisfying. However in the last century the progress of statistics combined with computer science and the boom of the data mining industry enabled loan providers to understand and predict consumer behavior. Techniques using computerized predictability algorithms were born. As early as the 1980's, these cutting-edge techniques enabled banks to offer quick and appropriate lending schemas.

Today, statisticians build extremely accurate models with thousands of variables combining demographic, geographic, socioeconomic and historical factors collected over huge samples of population; to do so, the spending habits of millions of actual consumers are recorded over several years. Credit statisticians give more or less weight (i.e. importance) to some variables depending on the value of others; this gives predictability formulas a quasi organic ability to foresee how a consumer will react in any situation. The formulas also allow them to compare potential loan candidates with a similar consumer background and therefore identify risk categories. The number of accounts people open, the age of those accounts, the number and type of credit card they use, the amount of savings, the income regularity: all these factors are tracked to pigeonhole financially active individuals into specific risk categories.

This leads to what now accompanies any consumer in America (and most other developed countries): a scorecard called a credit score, so he or she can apply for loans. Simply put, there are two main types of credit loans available. Loans for homes and mortgages and loans for consumer retail purposes like shopping for a new car, fridge or any domestic appliance. This scorecard defines how easy your life as a consumer is going to be; without good credit, forget about obtaining even the smallest loan from a bank or department store. You must have a decent credit score if you plan on asking any financial institution for a loan to buy a house or remodel your kitchen. Your credit score is the first thing lenders will look at to determine which risk category you belong to.

Your credit score is like a school report card

Higher is better when it comes to your score. On average most people in the U.S. score around 692, which is decent. Credit scores range between 300 and 850, with only 13% of the population scoring above 800. In general, a very good credit score is anything north of 700. Billionaire Warren Buffet has a score above 800. That is considered excellent, while a score between 700 and 750 isn't bad either. About 58% of the population has a credit score that range above the 700 range; another 15% land below 550. If you are part of the latter group no credit will be extended to you. Seriously, you won't even qualify for a Macy's card if your credit is 550 or below.

To put it in perspective get a score of 800 plus and the world is yours, 750 to 800 and you've got a friend at the bank. If you land between 700 and 750 lenders will take your phone calls, but score between 650 and 700 and those friends will dry up. Your credit is average if you score between 600 and 650. It's appropriate to cry if you score even lower than that because 300 to 600 is considered very bad credit.

What is a credit report?

Think of a credit report as your financial DNA. It's a make up of who you are relating to your history as a borrower. It's so significant a paper trail that it follows you throughout your life, fluctuating either higher or lower based on missed and made payments.

Any credit card accounts or loans you may have; the balances and how regularly you make your payments; any action that's been taken against you because of unpaid bills will be found in your credit report. The report is maintained by the 3 national credit bureaus, Equifax, Experian, and Trans Union. When you fill out an application for credit from a bank or retail store, your information is forwarded to the credit bureaus. They in turn match your name, address and other identifying information on your credit application with information retained by the bureau in its files and send it to whatever company you've applied for credit with.

It's important to monitor your credit at least once a year. You've got nothing to lose and federal law has made it easy for anyone to get one free credit report every 12 months. For this I use www.AnnualCreditReport.com, the only reporting website officially supported by all three credit bureaus. It has strict safety procedures that allow me to view my file on-line. And it's the only one that's actually free.

Are all credit scores born equal?

The answer is no. Your credit score will be different depending on which credit bureau you ask. Sometimes the difference can be quite striking (100 points or more) especially for credit histories that were established not long ago (resident aliens that came recently to the US, or teenagers).

The explanation for this is each credit bureau has its own method of calculating credit scores. As a result, even long established US consumers will notice small (single to double digit) differences in results. The most famous formulas used by credit bureaus are Equifax's ScorePower, Experian's PLUS score, and TransUnion's credit score. In addition to that, most major lenders such as banks and credit unions also have their own homemade credit formulas.

Many people mistakenly confuse the aforementioned credit scores with the FICO score. FICO is an acronym for Fair Isaac Corporation, a company created in 1956 by two mathematicians in Minneapolis. This company initially developed a specific risk indicator used by mortgage lenders, later known as FICO score. The success of their formula made it a tool of choice for other credit bureaus that adopted it as a base to develop their own formulas. Today Fair Isaac is a for-profit company that continues to sell its analytic and predictability models to bureaus, retailers, insurance providers and banks.

How to ruin your credit

Great question. It actually doesn't take much to ruin your credit. Here's how you can quickly achieve that feat.

How to improve your credit

Really it's simple - but it may take some time, since there is no quick fix for this. Start with paying your bills on time and you'll improve your credit score. Every missed payment will send your rating lower. Consider this: every month you pay your bills in full and on time, your credit score goes higher and higher. Within a year your credit rating can dramatically improve. But just one missed payment can halt that progress immediately.

So be careful not to get sucked (or suckered!) into the latest credit card advertisement or bank being peddled. As a savvy middle class consumer looking to crunch down your debt you must make sure to avoid the traps that lead to debt. Opening up lots of accounts too quickly will do more harm than good and you might be tempted to spend the credit lines you'll be offered.

The credit bureaus like to see that you can acquire and pay off a debt every so often. If you open a new account and pay that account's bills, it shows that you are reliable at paying off debt. This in turn will boost your credit rating.

Don't short cut by trying to pay off one credit card with another. Although this can be a temporary remedy to transfer existing high interest debt into a lower interest bracket to help you get ahead of it, this does nothing to reduce your debt or help your credit score. All it does is delay payment and you'll have to reimburse it anyway one day or another if you do not want to shatter your credit score. It's like "throwing good money after bad money". The only way to avoid paying extra fees is to pay with your bank account. Note that if you push this debt swapping trick too far, lenders will increase your APRs anyway. You'll lose no matter what.

If your credit score is terrible and you are desperate to rebuild it, besides paying your bills your best bet is to try and come up with $300 cash, and open a small secured credit line with this money. The bank will issue a card for you and you will use your own money instead of theirs following the exact same schema as you would with a regular credit line. Except that this time, you are your own lender. This is risk-free for the bank and chances are this solution will be accepted no matter how bad your credit score is. Pay your bills religiously at the end of each grace period and your score will slowly come back up. After about a year, you should be able to get your $300 back and ask for a regular, bank-issued credit line. Maintain your good habits when you use this one!

Lesser known credit tricks: the credit freeze

If you're the victim of identity theft, you can put a security freeze on your account. Of course, you won't be able to apply for a loan, credit card or new cell phone line while the freeze is in place because the freeze will prevent those companies to access your credit file. But the good news is the freeze makes it very difficult for anyone to fraudulently open bogus accounts or get an apartment lease under your name. Think of it as a damage control measure: the lock-down gives you and the competent authorities enough time to act and fix the problem, without dragging down your credit any further. Remember however that a security freeze will not prevent existing creditors from reviewing your account for collection purposes.

Later on, when fraud issues have been fixed and you feel ready, simply contact the credit bureaus and ask them to lift the freeze. They are required to do so no later than three business days after receiving your request.

How is it done? To lock down your credit report, contact each of the three credit reporting agencies, Experian, Trans Union and Equifax. In most states if you've been the victim of identity theft then it's free to lock down your file, as long as you have a report from either the local law enforcement agency. California residents who are not identity theft victims must pay $10 to freeze each credit report, or a total of $30 to freeze their files at the three credit bureaus. With a credit lock-down, a criminal can have your name, birthday and Social Security number - but it won't matter. No credit will be issued.

Send the letter by certified mail only to all three addresses below.

Equifax Security Freeze P.O. Box 105788 Atlanta, GA 30348

Experian Security Freeze P.O. Box 9554 Allen, TX 75013

Trans Union Security Freeze P.O. Box 6790 Fullerton, CA 92834-6790

 

 

 

 

including the following information:

• your full name,
• address,
• Social Security number,
• date of birth,
• all the addresses where you have lived over the prior 5 years,
• proof of current address such as a current utility bill or phone bill,
• photocopy of a government issued identification card, e.g. state driver's license or ID card, military identification,
• if you are a victim of identity theft, to avoid the fee you must include a copy of report of alleged identity fraud or an identity theft passport. Pay the fee by check, money order, or credit card.

To make your life easier, we provide you here with a credit freeze letter sample:

Date: _______ Equifax Security Freeze, P.O. Box 105788, Atlanta, GA 30348                                                           Dear Equifax, I would like to place a security freeze on my credit file. My name is: _______  My former name was (if applies): _______  My current address is: _______  My address has changed in the past 5 years. My former address(s) was (were): _______  My social security number is: ___-__-____  My date of birth is: __/__/__ I am an identity theft victim and a copy of my police report or police docket number documenting identity theft is enclosed.  (or) I have enclosed the $10 fee, photocopies of a government issued identity card AND proof of residence (such as a utility bill or phone bill). Yours truly, (Your name and signature)