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What is credit?
Basically, credit is where someone loans you money that you promise to pay back at a later date, under repayment terms to which you both agree. Lenders earn money from the interest that accrues while you are paying back the loan, whether it is in the form of a credit card, student loan, car loan or mortgage.
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Credit history
There is always the risk that someone won't pay back their loan, so creditors try to assess and reduce this risk by
reviewing your credit history, since past financial performance
is often a good indicator of future behavior. Your credit history shows things such as whether or not you have made payments on time or exceeded
credit limits, how many accounts you have, how long they've been open and what their credit limits are, and average balances owed. Potential employers and landlords may also use it to gauge whether you are
financially responsible.
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Credit reports
Among the tools lenders use to assess your credit history are credit reports available from the three major credit bureaus:
Equifax, Experian and
TransUnion. At your or a potential lender's request, credit bureaus will
compile a credit report — which is basically a snapshot of your credit history at that moment.
Keep in mind that negative information, like missed or late payments and bankruptcy, can take years to "fall off" your credit report.
However, newer, positive credit activity, such as on-time payments and paying off balances, can raise your credit score.
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Ordering credit reports
You can either order reports from each of the bureaus directly for a small fee, or get one free credit report per bureau, per year at www.annualcreditreport.com. It's a good idea to order a free report from a different bureau every four months from this site so you will know what lenders and others are being told about your credit history. It also allows you to spot fraudulent activity or errors year-round, before they damage your credit, since the bureaus are required by law to investigate any disputed item and correct inaccuracies.
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What is a credit score?
Credit bureaus use information in someone's credit report to create a three-digit credit score — typically ranging between 300 and 850 points.
The most commonly used credit scores are called FICO scores, named for Fair Isaac Corporation (FICO), which developed the proprietary software.
The following five components are considered and weighted when determining your FICO score:
Payment history (35%)
Amount owed (30%)
Length of credit history (15%)
New credit accounts (10%)
Types of credit used (10%)
Whenever you apply for credit or a loan, lenders determine if you are a worthy credit risk by evaluating one or more of the bureaus' scores along
with their own criteria, such as income or length of employment. Your overall credit score may affect not only whether or
not you qualify for the loan, but also the amount, term length and interest rates.
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How to establish credit
Good credit is something you have to earn by demonstrating sound financial habits. Ways you can begin to establish and build strong
credit include:
Apply for a small loan and pay it off fully and on time (see "Understanding loans").
Open a credit card account (see the discussion on secured and unsecured cards) and pay off
the credit card balance in full each month.
Wait until you feel confident that you are managing your spending and payments. Then ask to have the credit limit on your card increased —
but don't increase the amount you actually charge on the card. Remember, lenders like to see a lower ratio of debt to available credit.
Before opening a credit card or loan account, make sure the lender agrees to report on-time payments to all three credit bureaus —
this will help build your credit history.
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Ways to build good credit
If you are new to credit, it will take time to establish a strong credit history and earn a high credit score. The best way to do it is by using
credit responsibly over time. A few suggestions include:
Always make payments for credit cards, loans, utilities or other bills on time.
Try to pay credit card balances in full each month; avoid making only minimum payments.
Avoid keeping your credit card balance at or near the credit limit and don't exceed it. Consistently using most of your available credit
can hurt your credit score.
Resist applying for numerous accounts, because excessive credit inquiries by lenders can lower your score.
Try not to make frequent balance transfers from one account to another.
Finally, it sounds silly, but unpaid parking tickets, library fines and other fees can show up on your credit score as unpaid debts.
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Future implications
Failure to manage credit responsibly can have an adverse effect on your credit for years to come. For example:
Your credit card interest rates could rise suddenly and dramatically.
It could be difficult to obtain new credit or loans.
You might have to put down large deposits to open utility accounts.
You might even have trouble renting an apartment or getting a job if the prospective landlord or employer runs a credit check.
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