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13 April 2021

What is credit? You might have a credit card or a line of credit, but do you know all the facts and how it can affect your life? With how influential credit scores are, it's vital to understand the scoring system. With the right knowledge, you can improve and build upon your number and make the best financial decisions for you and your family.

You’ve no doubt heard about credit, credit scores and how they’re necessary to do everything from building your credit to buying a car or house. What you may not know is all the facts and information about credit. At Teachers, we want to arm you with all information possible so you are empowered to make the best financial decisions for you and your family.

With how influential credit scores are, it's vital to understand the scoring system well enough to understand how you can improve and build upon your number.

How Credit Works

Credit is simply an amount of money a lender is willing to give you to make purchases when you don’t have enough cash on hand to pay in full. Financial institutions will extend credit, or loan you the money to make the purchase. To help estimate overall risk on this loan, the lender will use your credit score to help gauge how likely you are to repay that obligation.

How a Credit Score Works

A credit score is a three-digit number ranging from 300 to 850. Your score acts as a signal to a lender showing how likely you are to meet your financial obligations.

In general, if you have a low credit score, you are viewed as being more likely to miss or be late with payments on loans or debts. If you have a high credit score, you are viewed as being more likely to pay your obligations in full and on time.

While there are many different scoring models and systems, the most commonly used and known model is the FICO credit score. This scoring system was created in 1956 by Willam "Bill" Fair and Earl Isaac, who developed Fair, Isaac, and Company—now known as FICO.

Other models have gained popularity in recent years, such as VantageScore, and while that can get confusing, the good news is that none of them are looking for anything vastly different. This means that the same financial habits will usually help you no matter the credit score evaluation model.

Your credit score will affect many aspects of your financial life. A few examples are:

  • Qualifying for a credit card, or a home, auto, or personal loan

  • The interest you will pay on loans and credit cards

  • Home and auto insurance rates

  • Qualifying for a home rental

  • Obtaining home utilities and cell phone service

As you can see, your credit score is important. Understanding what factors determine your credit score will allow you to build healthy financial habits that help establish and build your score over time.

The Calculation

While much of the formula used by the scoring systems are not openly shared, some elements are made available to the public.

Your FICO score is a calculation of:

  • Your payment history (35%)

  • How much you owe on your open accounts (30%)

  • How long your accounts have been open (15%)

  • The types of accounts you have open (10%)

  • History of opening or seeking new credit (10%)

While these percentages are specific to the FICO model, other models are likely to use these same categories in their formulas. One category may count for a bit more or less, but these are the foundational items for you to consider the bedrock of any credit scoring model.

What's In and What's Out?

Generally, when any credit line is extended to you, you can assume it will show up on your credit report. Credit cards, student loans, personal loans, installment loans, car loans, and home loans are the most common items on credit reports. Any time you open or attempt to open these types of accounts, it will likely appear on your credit report, and therefore affect your credit score.

A good rule of thumb is if your credit is checked to obtain a loan or item, there's a good chance it may be reported to the credit bureaus—the main three being Experian, TransUnion, and Equifax.

The exceptions to the above are a few common monthly obligations that are not reported to the credit bureaus. Things like rent for an apartment, a cell phone bill, or a cable bill are not lines of credit and therefore do not appear on your credit report unless you fall behind on them. In that case, the unpaid balance may go to collections and is likely to become a negative remark on your credit report.

It helps to know that there are other factors that determine your eligibility for a line of credit. The stability of your income, for instance, will often be considered when applying for a loan.

Improving Your Credit

Your credit score will not just determine your eligibility for a loan but also the specific terms you qualify for. A low credit score can often result in a higher interest rate. One part of how credit card interest works is based on your creditworthiness. The higher your score, the more likely you are to be approved and eligible for a lower interest rate. The lower your interest rate is, the less you are charged for your purchases on the card. On the other hand, the lower your credit score is, the higher your interest rate will be, and the more you will be charged for your purchases. Because of this, improving your credit score can save you money in interest and fees on lines of credit extended to you.

Anyone can request a free copy of their credit report every 12 months from each of the three major credit reporting agencies. If you're trying to improve your credit score, this is an important first step to take as it can give you a full view of where and how your credit is being impacted.

Once you've obtained a free copy of your credit report, look to see if you've fallen behind on your bills and try to get caught up. If you find that you’re struggling to catch up on your payments, we offer services to help you get back on track.

If your score is low and you aren't sure why—maybe you've never fallen behind—review your credit report for inaccuracies. Mistakes can happen. As mentioned above, you're entitled to one free credit report from each of the three major credit bureaus per year. If you find any errors, you can go to their websites to obtain instructions on how to go about initiating a dispute.

Once you've done that, you'll want to stick with the basics:

  • Make regular, timely payments

  • Keep your balances low

  • Don't apply for new credit too frequently

Final Thoughts

While credit reports and scoring systems are very complex, the basics don't really change. The simple fact is that your financial habits will determine your credit score. If you pay your bills on time, make good use of your available credit, and don't go overboard in seeking new lines of credit, you’re moving in the right direction. If you make errors, just try to correct them. By using your credit knowledge and making strategic choices, you will be well on track for a sound—and credible— financial future!