Debit cards, ACH transfers, and checks are great ways of transferring money from one account to another, but how do you buy something that costs more than what you have in the bank? You can purchase things that cost more than you have on deposit by using credit. Credit is money that is loaned to you by a financial institution like a bank. Banks will determine how much credit they will offer you based on their judgment of your ability to repay the loan. When you repay the loan, you also pay interest. Interest is a percentage of the loan that you agree to pay to the bank as a fee for the privilege of being able to use the bank's money.
Credit History: The Basis for Credit
There are a number of factors that affect your ability to get credit of any kind from a financial institution. Your credit history, income, and existing debt influence whether or not a lender will approve your application for credit. The higher your income and credit score (explained below) are and the lower your debt is, the more likely it is that a lender will look favorably on your application. The lending institution will pay particular attention to your debt-to-income ratio (DTI). DTI is the relationship between how much you owe and how much money you make. A healthy DTI is around 20-25%. A person with this ratio spends $20-25 of every $100 earned servicing debt (e.g., paying interest on loans). There are various ways of calculating your DTI ratio, but one of the more common ways is to add up all your monthly minimum payments and divide that by your net (post-tax) income.
In addition to examining your DTI, a potential lender will also review your credit history. Your credit history is a summary report of your debts, payment amounts, and payment dates. It is a gage of how well you have handled your financial affairs in the past. Financial institutions, employers, and other authorized entities order such reports when you apply for credit or employment. Although the information contained in your credit report is about your past behavior, that past behavior is generally a good predictor of your future behavior. That is, if you paid your bills on time in the past, it is likely you will do so in the future and vice versa.
The Credit Bureaus
Where does credit history information come from? Financial institutions such as banks and credit card companies report your payment history and account balance information to one of the three major credit bureaus (Experian, Equifax, and TransUnion). The credit bureaus record the information and use it to calculate a credit score for you. Most credit bureaus use the Fair Isaac method (FICO) to calculate this score. The exact method is kept secret, but the following aspects of your past financial history are important:
- number of on-time/late payments (weighted 35%)
- amount of debt (weighted 30%)
- length of credit history (weighted 15%)
- new credit (weighted 10%)
- the types of credit you use (weighted 10%)
Keeping debt low relative to your income and making all payments on time are the best ways to get a good FICO score (700 and above). FICO scores, in general, range between 300 and 850. Scores in the 650-700 range are decent, but anything lower than a 600 is considered marginal and a poor risk.
Although your credit report is comprehensive, there is some information it does not contain. Your driving record, checking/savings/investment account balances, medical history, religion, and national origin information do not appear in your credit report.
As stated above, late payments negatively affect your credit rating negatively. Late payments are generally referred to as derogatories. Derogatories are categorized by "buckets" (ranges of time that you are late in making your payments. Typical bucket ranges are 0-30 days, 31-60 days, 61-90 days, and 90+ days. These buckets characterize how many late payments you have had and the degree of lateness. If you once made a payment 45 days late, that late payment record will appear under the 31-60 days bucket on your credit report. Such black marks stay on your credit report for 7-10 years depending on what type of derogatory they represent. Delinquencies (late payments) stay on your credit report for 7 years. Bankruptcies can stay on your credit report for 10 years. Tax liens are a special case and can stay on your report for up to 15 years. It is NOT always true that derogatories will automatically "fall off" your credit report after 7 years. The Fair Credit Reporting Act (FCRA) is a federal law that limits the length of time a charged-off account can remain on your credit report. Although it states that bad debt can remain on your report for 7 years from the date of last activity, in some instances you will have to send a written request to all three major credit bureaus to have the old information removed from your record.