The Everything Improve Your Credit Book: Boost Your Score, Lower Your Interest Rates, and Save Money

Introduction

illustration PERSONAL CREDIT HAS BEEN important throughout history, and it continues to become more important. The world has become a much bigger place, and therefore your credit is used more often. Because lenders and other service providers cannot possibly know everything about you, they check your credit. Your credit is far more than a record of your borrowing habits — people also use your credit to judge your character. While many people understand that loan terms depend on their credit, many people do not understand the other ways that credit affects their lives. Depending on your credit, you may be more or less attractive as a job candidate or insurance-policy holder. If you already had some idea of how important your credit is, you're way ahead of the game. A large percentage of the population doesn't even know that a credit score is an indication of your risk as a borrower.

Credit is misused and misunderstood by many. Some people find the topic too confusing or too intimidating to understand. Others believe that they are powerless, that their credit controls them, and not vice versa. Nothing could be further from the truth. You can understand how credit works, and you can make it work for you. Credit is a powerful tool that you can use in your financial life. However, if you do not understand the world of credit you are, in fact, powerless. You'll simply have to take whatever offers you can get, and those offers probably won't be the best ones.

This book is designed to demystify the world of credit and credit scores. Knowing how this world works will empower you to manage your credit to your own advantage. You can start to think of your credit as your friend, not a skeleton in your closet. Your credit can get you things that you want, and it can help you save money. You'll have a clear idea of what your credit is, and how credit scores function in your life.

Your credit will be with you for a lifetime, so you should know how to manage it from start to finish. Things do not always work out the way we would like, so this book also prepares you for some of life's more challenging events. You can protect your credit from the unknown, and pick up the pieces when disaster strikes. If all goes well, you can continue to build on your successes. You'll discover secrets to developing great credit, and you'll learn about the traps that trip most people up. When it comes to credit, ignorance is not bliss. You can make your life easier by knowing how the system works and how to work within it.

The world of credit is actually quite fascinating. The world as we know it has evolved over years and years of borrowing, defaulting, repaying, and more. Consumers, lenders, and regulators have all done their part to bring about the current state of affairs. This book should fascinate you and educate you about the world of credit. Those completely unfamiliar with the world of credit will learn the basics, and they'll know what to do to make their credit a little better. Seasoned borrowers can also benefit from some of the more advanced information in this book. No matter what your level of expertise, you'll find information you can use to make your credit work better for you.

1

Understanding Credit

Is credit a mystery to you? It shouldn't be. Instead of being intimidated by be. Instead of being intimidated by your credit and how the world of credit works, you should think of credit as your friend. In this section, you will get to know your friend a little bit better. You can find out where it came from, what it does, and where it is going. You will also understand what credit reports and credit scores are.

Your Financial Reputation

Your credit is simply your financial reputation. It gives lenders, and others, a tool to help decide whether or not they will do business with you. If you want to use their services, they want to manage their risk. The last thing a lender wants to do is give out money, only to have the borrower default on the debt. When this happens, the lender loses money. Of course, lenders are not charities — they are in business to earn money from interest payments, not to lose it.

The system of using credit in the United States serves a variety of purposes. First, this is a big country with a lot of people. It is difficult for any business to know everything about everybody. When the world was a much smaller place, a lender might make a lending decision based on an individual's reputation. In small communities, this would be easy. However, these days most loans come from large national, or international, organizations. They don't know your personal reputation, so they have to check your credit. In this way, credit serves as a way for lenders to share information so that they can make good decisions.

The fact that everybody can share information about you is extremely significant. Knowing that your creditors will spread the word about you gives you an incentive to pay your debts as agreed. If you knew you could borrow money and get away with defaulting on the debt, you might be tempted to do so quite often. After all, free money is enticing. Alas, there is no such thing. You might get away with it once or twice, but you will build up a bad reputation. Creditors depend on the fact that you want to have a good reputation so that you can borrow from others in the future.

Where Credit Information Comes From

Where does your credit come from? Are you born with it? No — if you don't use credit, you don't have credit; your credit is a result of your behavior in the world. Some of the most important information comes from your dealings with creditors. Of course, it is your credit, so the most relevant information comes from your use of credit.

Information Sources

The information that makes up your credit comes from numerous sources. Other sections of this book describe the sources in greater detail. For now, suffice it to say that there are a lot of organizations talking about you:

Lenders

Prospective lenders that you never worked with

Government and court systems

Collection agencies

Credit-reporting companies

Depending on how you define your credit, information can come from a number of additional sources. Insurance companies report information on their customers to specialized databases. Landlords who rent properties share and use information about tenants. Finally, banks and retailers may share information about your check-writing habits.

Credit Scores

When you think about credit, you may think of the concept of a credit score. What exactly is a credit score? The credit score is a number that attempts to rank you on some level of creditworthiness. The credit score might tell potential lenders how likely you are to make late payments.

Your credit score does not determine whether or not you get a loan. The credit score is simply a number that ranks you with the rest of the population. Your lender may have a policy on granting loans based on credit scores, but the scoring programs do not know that. They just generate a score.

Imagine how difficult it must be to predict whether or not a customer is likely to pay late. Imagine yourself as a loan officer in a bank sitting across the desk from a potential borrower. What criteria do you use to judge this person's creditworthiness? You may pull credit reports from the major credit-reporting companies — if you have ever seen these reports, you know that they are full of information and can be several pages long. Then, you might read through their reports to get an understanding of how your potential borrower has behaved in the past. Finally, assume that you have three more potential borrowers waiting to see you, and you have not had lunch yet.

This scenario helps to highlight why credit scores may be useful. People have to make lending decisions with several goals in mind. They may want to grant the loan so that their organization earns interest income. They may also be motivated to grant loans in an effort to help serve the community, for example, making mortgage loans available to low-income households. On the other hand, the person making the lending decision has to try to minimize losses. The organization won't be able to help anybody if it loses all of its money.

Automate It

To make lending decisions easier, lenders often use credit scores. A computer program does a lot of the work, leaving just a few items for the person responsible for making a decision to fill in. In some cases, the computer program does all of the work, and human eyes never see the potential borrower's credit information. The credit-scoring model looks for good things and bad things in the borrower's history. It looks for late payments, bankruptcies, and maxed-out credit cards, among other things. These are the same items that a human would look for. Of course, the computer can do it in a split-second.

A 2005 study released by the Consumer Federation of America and Providian put a number on how much you can save with a better credit score. For consumers with an average credit score, a thirty-point increase would result in $76 of annual savings on finance charges. Of course, more significant positive changes in your score would yield more significant savings.

In addition to speeding up the process, credit scoring can level the playing field. Lenders might have biases that influence their decisions when considering an applicant's creditworthiness. From a fairness standpoint, creditworthiness should be the only factor considered. However, people responsible for making lending decisions might be swayed in one direction or the other for irrelevant reasons: if the applicant is good or bad looking; if the applicant has a health issue with negative stigma attached; or if the applicant seems friendly or unfriendly. In some cases, lenders may discriminate because of an applicant's sex, race, or creed. Credit-scoring models can eliminate these biases from the equation, because they look strictly at the credit history data. If the applicant has a good credit history, the score is high regardless of any personal traits.

Who to Lend To

Credit scoring makes it possible to make a large number of small loans. Lenders get flooded with applications for credit. How do they determine which ones to process? If they are strapped for resources (time and person-nel), they might decide to limit themselves to the loans that are more profitable. In this case, they might focus on the larger loans only because smaller loans require the same amount of processing but pay less interest. Credit scoring makes it efficient to look at loans of all sizes, which makes it easier for consumers to get loans.

Where Scores Come From

Where exactly do these credit scores come from? There are a variety of companies that create credit scores. These companies are described in greater detail later in this book. For now, you should understand that the credit score may or may not come from your lender. In many cases, it does not. External companies create the computer programs used to generate scores.

The computer programs are just empty programs that take in information and process it. They're designed to work with different systems. For example, the FICO credit score is designed to work with the data held at the major credit-reporting companies (TransUnion, Equifax, and Experian). The credit-reporting companies load the software, and then load the credit history for the individual who they are going to score. The software spits out a score, and it is forwarded to whoever asked for the report.

Mass Confusion

The world is full of confusion about credit scores. In part, this is because credit scores were unavailable to consumers for many years. In addition, the entire world of credit and credit histories can be intimidating. Unfortunately, ignorance is not bliss when it comes to your credit. The majority of consumers, 69 percent of them, have not checked their credit within the last year.

In 2005, a study released by the Consumer Federation of America, Providian, and myFICO.com explained the state of affairs. They found that about half of the American population does not understand the basic concept of a credit score. Indeed, only 51 percent of respondents in the study knew that a credit score represents credit risk. The other 49 percent thought a credit score described credit availability, credit IQ, or levels of debt. In addition, 45 percent of respondents thought that getting a substantial pay increase would result in a higher credit score. While it is possible that there might be an indirect link between your pay level in your credit score, many highly paid people borrow too much (the more you earn the more you spend) and can end up with a very low credit score.

Not All Scores Are the Same

Many people are under the impression that they only have one credit score. In fact, if you have one credit score, then you likely have many more credit-based scores. For the most part, when a lender refers to your credit score they are talking about your FICO credit score. This is a score based on the Fair Isaac Corporation's credit-scoring model. At the present time, it is the most commonly used score.

When you take on the goal of improving your credit, it is essential that you get a little bit more specific. You need to know which credit score you need to improve. That will depend on your current goal, whether it's buying a house, getting insurance, or landing a job.

Variations on the Theme

While the FICO score is the current gold standard, you most likely have several FICO scores. Each of the three major credit-reporting companies can calculate a FICO score for you, but they also sell their own proprietary scores which are not based on the FICO model, so be careful what you buy. Because the major credit-reporting companies all have different data on you, your fic o credit score will most likely be different at each company. Most experts suggest that you use the middle credit score (not the highest or lowest one) as a gauge of your creditworthiness. Your lenders, on the other hand, might use a different method. They might give you the benefit of the doubt and use your highest score, or they might just buy a single score from one of the credit-reporting companies that they have a relationship with. If you are not sure which score they will use, just ask.

A lot of organizations will offer to sell you a credit score. Before you fork over your hard-earned money, find out what you're getting. Scores from different sources can look deceptively similar, but you need to use the same score that your lender is using if you want to know where you stand.

Other Scores

There are other scores in addition to your multiple FICO credit scores, and any company that you do business with may have its own internal model. The most common internal model might be an application-based model. These models judge your creditworthiness using information you provide on your credit application. For example, your lender may ask how long you have lived at your current address, how much money you make, or how long you have worked at your current job. Of course, lenders won't make a lending decision based solely on your answers to the application. Instead, they use that information as a supplement to the information found in your credit history.

VantageScore

VantageScore is a relatively new scoring model developed by the three major credit-reporting companies: Equifax, TransUnion, and Experian. They suggest that the FICO credit-scoring system is too confusing for consumers. FICO scores range from 300 to 850. A pretty good score is 750, but you might not know that by looking at it. VantageScore uses a scoring system much like your high school teachers', with scores running from 500 to 990. If you remember the good old school days, a 99 percent was an A, anything from 80 percent to 90 percent was a B, and so on. The credit-reporting companies are hoping that this simplicity will help them win market share.

Behavior Scores

The scores described so far are used for a specific purpose, like deciding whether or not to grant you a loan, and at what terms. However, your credit information is used for a variety of other purposes. These stores might use the same credit-file data as your classic FICO credit score, but they analyze the data in a different way. In addition, they might incorporate information from other sources. The goal of these scores is to understand other parts of your behavior.

Profitability Scores

One of these scoring models is designed to determine how receptive you might be to new offers from your credit card company. If you are more likely to accept a given offer, the company is more willing to splurge and mail you an advertisement. Somehow, the way you use products and accounts can reveal how likely you would be to say yes.

Other scoring models help your creditors predict how profitable you will be as a customer. They get an idea of how much revenue you will generate, and they can predict how likely you are to switch brands. Presumably, they make attractive offers to customers who are less likely to switch, and they might create incentives (or penalties) to retain customers who are likely to switch.

Bankruptcy Scores

Creditors can even score you on the likelihood that you will declare bankruptcy. Not surprisingly, your credit history is a main ingredient to the score. A bankruptcy score is slightly different than your FICO credit score. The FICO score attempts to rank you based on the likelihood that you'll be ninety days late on any bill with any creditor. The bankruptcy score goes even further: it tries to determine whether or not you will declare bankruptcy and default on all of your debts.

Expanding the Reach

The FICO scoring model can only generate a credit score for you if you have a sufficient credit history. If you have not used credit accounts enough (perhaps because you are young or a new arrival to the country), there will not be enough data in your credit history to generate a score. In the past, individuals without a score had a hard time getting credit. However, Fair Isaac has remedied this situation in recent years. They created a score they call the Expansion credit score. This score judges your creditworthiness based on information from alternative sources. They examine your past for evidence of bounced checks, delinquencies with service providers, and other behaviors that might describe your creditworthiness.

The best thing you can do for yourself is be a responsible consumer. Pay your bills on time, and don't bounce checks. If you get in over your head, your credit scores will follow. A lot of different organizations check into your credit, so just do a good job and make it easy on yourself.

If your credit history is not sufficient to generate a FICO credit score, then you may be able to get credit because of the Expansion credit score. Once you get your foot in the door with lenders, you are building up your credit history. Over time, there will be enough information about you in the major credit-reporting company databases. As a result, they will be able to generate a FICO credit score on you eventually.

Insurance Scores

Insurers look at your FICO credit score to determine whether or not you are an attractive customer. In addition, there are specially designed insurance scores that help them further evaluate you. Based on your ranking, insurers may decide that they do not want you as a customer, or they might offer you coverage at higher-than-normal rates. The reverse is also true: if you score well, insurers may offer you a discount.

What's Not Part of Your Credit

The body of information called your credit is quite extensive. It contains data on all of the following:

Every credit card you've ever used

Every loan you've applied for Every loan

you've actually used

Any public records relevant to your credit

Your residence and employment history

And more

While some of these items may not appear in a given credit report, they are still part of your credit. However, your credit does not tell the complete story about you. There are a variety of things that are not part of your credit.

Irrelevant to Credit

A number of characteristics that might describe you are irrelevant to your credit because they have nothing to do with your creditworthiness. For example, certain characteristics are excluded by laws designed to limit discrimination. Of course, some of the common ones are race, color, religion, national origin, and sex. In addition, lenders may not discriminate against you based on the likelihood that you will have children or get married.

Despite these regulations, some of this information may be used by a potential lender. Although a credit-scoring model will ignore these characteristics, a human who looks at your credit report may be able to make some educated guesses. They may be able to guess your race or national origin based on your last name. Likewise, an applicant named Robert is most likely a male, while one named Susan is probably a female.

In the 1700s, borrowers could end up in prison if they did not pay their debts. Debtor's prisons punished defaulted borrowers, a stark contrast to today's practices. Ultimately, lawmakers found that debtor's prisons did not create enough of a deterrent to keep people from defaulting, and they are no longer used.

Your Personality

Your personality is also irrelevant to your credit. You may be the nicest person in the world, but you won't get a loan unless you have good credit. As the saying goes, actions speak much louder than words. Creditors will base their lending decisions on their knowledge of your previous actions. In some cases, you have the opportunity to sit face to face with a lender and explain that you have no intention of defaulting on your debt. For the most part, that's not an option. You have to work within the system and build good credit.

Your Burdens

Whether you love it or hate it, your credit just reports how you have paid your debts in the past. You might have missed some payments, or defaulted entirely, for a variety of reasons. Perhaps it was because you took on more debt than you should have. On the other hand, a freak accident or sickness could have overwhelmed you with medical bills. Whatever the case, your credit does not care. Credit scores don't explain why you missed payments or declared bankruptcy. They just slice and dice your account history and spit out a number.

Your Paycheck

Some people think that your salary is an important factor in your credit. It certainly is important for some scoring models, and those that ask for your salary on the credit application are obviously going to use that information. However, salary may be less important than you think. It is not a part of the FICO credit score. Therefore, you can have a high credit score even with a modest income. All you have to do is use credit wisely.

Who should I contact with a complaint?

If you feel that you have been discriminated against, or you have any other credit-related complaints, start with the Federal Trade Commission (FTC). Their Web site ( www.ftc.gov/credit ) has a wealth of information on your rights. From there, you can find out exactly who to contact.

The opposite is also true: you can have a terrible credit score even with a million-dollar income. Creditors don't care how much money you have, or how much you make, they just want you to pay according to the terms of your agreement with them. If you can't do that, they get nervous and would prefer not to deal with you.

Net Worth

Creditors don't care whether you are rich or poor. Again, they just care how you manage your credit. You can have bad credit even if you have a lot of money in the bank and another million or two in the stock market. Granted, you could pay off your debts without batting an eye. However, your creditors do not want to spend extra time, money, and energy collecting debts from you.

A Brief History of Credit History

How did we get to this point? Credit is a part of our everyday lives, and good or bad credit can make you or break you. Because of credit, you can buy a home for