Tuesday, March 31, 2009

Turn You Inside-Out

Back in the good old days, you would have lived in a town with one or two banks.  If you needed to borrow money - to buy a house, or start a business, or get through a rough patch - you would have gone to the banker.  The banker lived in your community, and would know (or could find out by word of mouth) whether you had steady employment, how good you had been at repaying your tab at the bar, what kind of assets you owned, and so on.  Based on this information, the banker would decide whether or not you were likely to repay the loan, and would decide how much he felt comfortable lending you, and at what interest rate.

That time is long gone.  Instant communication and international corporations have made lending a global commodity.  You can get a mortgage from any one of hundreds of banks.  The people making those decisions live far away, running computer programs to crunch numbers and determine whether you're a good risk.  They don't know you.  So, how can they decide whether and how to issue you a loan?

In parallel with the globalization of lending, we've witnessed a globalization of personal information.  It's no longer people in your community who keep track of you: every bank, credit card, school, and employer you've ever had are collecting information about you and sharing it with one another.  This is very convenient for the lenders... even if you've moved to Texas, they can still learn about that bankruptcy you had in North Dakota.  It's less convenient for you, except to the extent that it enabled you to shop around for more lenders.  A credit card company in Maine wouldn't consider giving you a card unless it could have some confidence that you won't borrow thousands of dollars and then disappear to Mexico.

What does this mean for you as a consumer?  That your actions today will have a profound impact on your finances tomorrow.  It's like your permanent record at school, except this actually exists.  As you make financial decisions, keep in mind that beyond the immediate impact of such decisions, they could affect your future ability to get credit cards, buy a car, buy a house, or even get a job or rent an apartment.

You have probably heard people talk about a "credit score."  A credit score is a numerical value that indicates how credit-trustworthy you are based on past behavior.  A higher score is better, and means that you're more likely to be able to get loans, and such loans can be for higher amounts and lower interest payments.  Lower scores have the opposite effect.  Some large employers or apartment complexes will check on your credit score, and won't want anything to do with you if they think your score shows that you've been irresponsible.

The following actions will generally raise your score:
  • Making payments on time.  This is the single biggest and best thing you can do.  The longer you've been making payments on time, the better you look.
  • Not using all of your available credit.  A person who has a $4000 limit on their card and is only using $1000 looks better than a person with a $1000 limit who is using $750.
  • Having credit for a long time.  Lenders like to see that you've been able to handle credit for many years without getting into trouble.

The following actions lower your score:
  • Missing payments.  The later it is, the worse it looks, and payments in collection are worst of all.  Lenders look at how recent a missed payment is, so if you were late last month, it will lower your score more than being late several years ago.
  • Bankruptcy.  This is a huge black mark that will follow you for many years.
  • Foreclosure.  See above, though this isn't as bad as bankruptcy.
  • Opening new lines of credit.  Over the long term, doing this might help your score, but in the short term, lenders get nervous if you seem to be borrowing a lot.
  • Using most of your available credit, even if you aren't late.
  • Closing accounts.  This is because your available credit goes down, making it look like you're closer to your limits.
  • Having an account closed.  During the credit crunch, some banks are unilaterally closing down accounts that haven't been used recently.  This has the same effect as if you closed it yourself.

And these things don't have any impact on your score:
  • Your income.  Your credit rating doesn't change whether you earn $10,000 a year or $100,000.  This doesn't mean that the lender won't consider it when, say, you're buying a house, but it's considered separately from your credit score.
  • Your savings, investments, or assets.  Again, for a major loan the lender will want to know these things, but a credit card company doesn't care if you have anything at all in your savings account.
  • Geographic location, employment, marital status, or other personal information.

There are three major credit bureaus: Equifax, TransUnion, and Experian.  Each keeps its own file on you.  Whenever you apply for credit, the lender may check one, two, or all three of them.  As you use your account, the lender will report information back to one, two, or all three of them.  As a result, it's entirely possible that some of your accounts or history will only show up on some of the bureaus, and as a result each will give you a separate score.  In practice, as long as there aren't any errors, all three bureaus will probably be in the same range.  This is because they all use the same, secret formula for converting your financial information into a score, called FICO.

The lowest score you can get is 300.  The highest is 850.  Higher is better, of course, but in practice lenders establish zones rather than sliding scales when making decisions.  For example, a lender will probably reserve their best interest rate and terms for people with scores over 720.  So, if you're already over 720, it won't do you any good to improve it to 800 or higher. 

There are many different types of scores out there besides FICO.  Credit reporting agencies push these because they're cheaper.  FICO is still the gold standard, though, and is the one people are most likely to look at.

If you want to see your credit score, you'll need to pay for it.  You can go to www.myfico.com to purchase your FICO score from the bureaus - it used to be all three, but they seem to be increasingly trying to differentiate themselves.

You don't, however, need to pay to see your credit REPORT.  The difference is that a score is just a number, a summary of how credit-worthy you are, while your credit report provides all the details of your financial history.  The score is the result of your report.

If any lender denies your credit request based on your credit score, you are eligible for a free copy of your credit report.  Presumably this is so you can see if there's any inaccurate information, correct it, and re-apply for credit.  You'll get a letter in the mail from the lender saying that you were denied and listing the bureaus they used in making their decision.  You can then go to each bureaus web site and, after hunting around for a little while, find where you can get your report.  I suggest searching for "denied credit", but their sites are likely to change over time.

Besides being denied for credit, you can also get a free credit report once a year by going to www.annualcreditreport.com.  Note that the once-per-year limit is applied separately to each bureau.  Because they tend to reflect one another, what I like to do is stagger my reports - for example, checking Experian in January, TransUnion in May, and Equifax in September.  You can request your report online, but in some cases they will require you to fill out and mail in a form to do this - that's generally the case if the personal information you provide them doesn't match what they have on file, which generally indicates that there's an error.

Once you get your bureau credit report, scan through it and look for errors.  I had a bit of a mess a few years ago when Experian got me confused with another Chris King and imported all of his (very bad!) accounts into my report.  For some things you'll be able to make corrections online, but for others you'll need to call them directly.  In both cases, when you point it out, they'll do an internal investigation, which will likely involve reviewing their own history and contacting the lender or merchant in question.  They're generally required to complete the investigation and make a decision within 30 days.  If you aren't happy with their final decision, you can provide a statement that will be inserted into your report describing your side of the story.  This doesn't have any impact on your credit score, but may make you feel better.

I highly recommend correcting even benign or beneficial errors.  For example, if they have an inaccurate address on your report, or an account in good standing that you didn't open, then in the future that account may go into collection, and you'll be hurt by it; it could take a year for you to discover that problem and fix it.

So, in summary, here are my recommendations for managing credit:
  • Start early and small.  I was fortunate enough to have parents who co-signed on a line of credit overdraft protection through my credit union when I was just 16 years old.  I never used it, but it showed up on my credit report - heck, it CREATED my credit report - and allowed me to start establishing some history.
  • Again: start small.  If you're new to using credit, it's very easy to get confused about how it works, to miss a payment, break your limit, or otherwise get yourself into trouble. Try to keep a credit card for emergencies only, and immediately pay any statements you receive in full.  This will show you're responsible and will do wonders for your credit rating.
  • Gradually open accounts or take loans as you need them, not to improve your score or because you can.  You'll want a credit card account by the time you leave college, and will likely have an active student loan, and maybe a car loan as well.  This is a good mix that will help you build a really solid history.  By contrast, opening a lot of accounts will hurt your score, and you won't be able to get a loan you actually need because you look too risky.  Furthermore, having a lot of accounts is just more complicated to manage, and increases the risk of making a single late payment.
  • Make payments immediately after you get the statement.  This may not always be feasible, at least when starting off, but try to do them as quickly as you can.  Again, this drastically reduces the risk of making a late payment.
  • Whenever you can, pay off a revolving credit line, like a credit card, in full.  This will keep you from paying any interest, help prevent going over your credit limit, and lower your overall credit utilization ratio, thereby improving your score.
  • Set up automatic payments for your debts, especially predictable ones like student loans or car loans.  This will ensure you don't ever miss a payment.
  • Consider paying off loans early.  If you accelerate your loan payments, your debt burden goes down and your score goes up.  And, of course, you're saving on interest payments as well.

You're keeping your credit score high for two reasons.  First, for the few times in your life that you need to make a big purchase like a house, it will help you get the best possible terms, both making the purchase possible and saving you thousands of dollars in interest.  Second, it keeps your existing lenders happy, so the rates on your credit cards and such stay low and your credit limits go up. 

Don't spend too much time worrying about your credit score.  I actually don't even know what mine is; I've been to cheap to pay to see it.  Just remind yourself to periodically make sure that your credit reports are accurate, keep making smart financial decisions, and everything will work out fine.

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