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Demystifying Credit


This could be considered a more practical companion piece to what I wrote yesterday. I was initially on the fence as to whether I should write strictly informational–that is, non-editorial/opinion articles–but I think there are areas where I can provide useful information to people, and this is one of them.

My credentials in the credit realm are 7 years working for a receivables management software company, as well as 17 years of utilizing credit in various forms: mortgages, auto loans, personal bank loans, credit cards, students loans. I’ve also experienced unsustainable levels of indebtedness, leading to chapter 13 and chapter 7 bankruptcies. The combination of these experiences has been educational, to say the least. What I hope to do here is remove some of the mysteries surrounding credit and debt more generally, and help others avoid some of the mistakes I’ve made over the years.

Some of this may be very basic. Just bear with me.

What is credit?

Credit is the ability to buy things without paying up front. There are a lot of facets to credit, but that’s the underlying concept. You get something now, you pay for it later.

What is it good for?

It must be said that this article is not a blanket endorsement of using credit. Many forms of credit are terrible deals from a financial literacy perspective. However, for most people credit is the only way to ever own a home, or a reliable car. With careful management, it is also possible to use credit cards in a way that maximizes convenience while costing you little or no money–or even making you money. If you are here, presumably you have some use for credit, and want to know how to get some (or more than you already have.)

How do I get it?

If you’re starting from scratch, credit can be hard to get. The first forms of credit most people are exposed to are student loans and credit cards. Since you initially have no credit history of your own, it is common to have a co-signer on your first loans and/or credit cards. In that instance, you are piggybacking on the creditworthiness of the co-signer. If you don’t pay, they’re on the hook–and it hurts their credit, too.

Another place to start is with secured credit cards. On paper, they sound like an absurd idea: you pay the credit limit of the card up front, and then you can use it like a credit card. Usually, you have to pay it off every month, as well. Why do this? Why not just spend your cash? Because a secured credit card helps you build credit!

What’s in a credit score?

Ultimately, whether a lender decides to extend credit to you is based on a combination of factors, and one of the most important among them is your credit score. Your credit score is based on one or more credit reports, which are records kept by a handful of companies (TransUnion, Experian, Equifax), essentially as a service to creditors. When you apply for credit, a potential lender can contact one or more of the credit bureaus to determine your current and past credit status. Credit scores, then, originate from the data in these reports. There are multiple kinds of scores out there: FICO, VantageScore, and some others. While their ranges and formulations vary, they care about more or less the same factors:

  1. The age of your credit history, in both absolute and average terms. This is based on how long your credit history is overall, as well as the average length of time all of your accounts have been open. A short average--that is, less than a few years--tells lenders you may have recently acquired a lot of credit, in which case you've become a greater risk. A good rule of thumb here is: pace yourself. Don't open multiple accounts in a short period of time.
  2. Total credit utilization, both overall and per line of credit. You should avoid using more than 30% of your credit limit on any one credit card (or other credit account), as well as keeping your total utilization among all accounts below 30%. Ideally, this is kept as low as possible, though it is actually not preferable to keep zero balances on all your accounts all the time, due to the next factor.
  3. Payment history. This one is more complex than it might seem, but there are some simple rules. First, every on-time payment made to a credit account is a positive entry in your credit report. This is why carrying zero balances all the time doesn't help you much. It extends the age of your credit history, but that is less important than having a solid payment history, which is only built by paying on accounts month after month. Even charging a balance and paying it off monthly will do the job: your _average_ balance is what gets reported, and each payment is a plus to your score. On the other hand, late and missed payments can hurt your score a lot. This is because, in addition to the total history, your percentage of on-time payments is very important. 100% is ideal, 99% is in fair territory, and anything below 99% is considered significantly risky. The only way to make up for a few missed payments is to make a _lot_ more on-time payments. This is why the sheer number of on-time payments matters so much, especially if you have any late or missed payments on record.
  4. Credit inquiries. There are two kinds: soft, which are informational and used when your report is requested for non-credit purposes; and hard, which result from applications for credit. Only the latter count. While these stay on your report for up to two years, in practice only hard inquiries in the past 6 months are scrutizined. It is normal to have a cluster of inquiries from around the same time, as it is common to shop around for the best deal on, say, a car loan or mortgage. However, it can hurt you if you have a steady stream of inquiries over time--this will appear to creditors as though you are desperate for credit.
  5. Total accounts. Your total number of credit accounts indicates to creditors how creditworthy _other_ lenders have considered you. Most are reluctant to be your first lender, but would be happy to be your fifteenth or twentieth. Due to this and to the fact that the age of your accounts both factor into your score, it may not be the best idea to close accounts you no longer have a use for, but rather to use them occasionally. That way, they will contribute to credit age, payment history, and total number of accounts all at once.
  6. Derogatory marks. More than perhaps any other factor, these can single-handedly inflict grievous damage on your credit. These are public records such as mortgage foreclosures, wage garnishments, bankruptcies, lawsuit judgments, and unpaid child support. Having just one of these on your report may deny you most access to credit. Unfortunately, most of them will stay on your report for 7 to 10 years, so they are difficult to get rid of, as well.

Managing these factors is less complex than it seems. Boiled down simply: pace yourself in terms of opening accounts; use your credit wisely and pay it off on-time, every time; don’t apply for credit unnecessarily; don’t close old accounts unless you have a lot already; avoid serious derogatory marks if at all possible.

This section is ostensibly about credit scores, but I didn’t speak much to the scores themselves. This is because obsessing over the number is going about it the wrong way. Manage your credit as laid out above, and your scores will increase. There is no secret or trick, just understanding what lenders care about and utilizing that knowledge in your credit decisions.

What if my credit is already bad?

I’ve had bad credit. Terrible credit, in fact: multiple delinquent accounts, followed by bankruptcy. The bad news is, in such a situation there is little you can do in the near term to improve your credit. The damage has been done.

But the good news is that nothing in credit is permanent. All the bad news falls off your report… _eventually._ After a bankruptcy or a severe bout of delinquency, it takes about two years to return your credit standing to a position where you may be able to acquire new credit accounts. The best way to facilitate this is to clear old, delinquent accounts from your credit report. There are essentially three tiers of approaches, depending on the severity of your situation:

  1. Contacting your creditors and working out payment arrangements/settlements. You can do this yourself. First, [obtain your credit report, for free.]( Find accounts on which you are delinquent, and contact those creditors. See if they will accept a payment plan or a reduced settlement. Before you do this, however, look into your state's statute of limitations on old debts. If it has become legally uncollectable, or about to, it's probably better to let it go, as it can no longer hurt your credit. If you do pursue paying it off, however, make sure that the creditor will close the account as "paid in full." What they are not legally allowed to do is remove delinquencies, so it's not worth asking.
  2. Seeking credit counseling. If your debts are too overwhelming to tackle individually, a credit counseling company can help you work with your creditors to come up with a single monthly payment that will begin paying down all of your debts. [The FTC is a good resource on information about credit counseling.]( A good credit counseling agency can help you get your consumer debts paid down in a few years.
  3. Filing for bankruptcy. These days, it is required to pursue credit counseling first, but if it is determined your debt situation is dire enough that even credit counseling won't help, there is still bankruptcy. While not all debts can be eliminated in bankruptcy (child support, alimony, student loans, government fines, some taxes), other debts such as credit cards and medical bills can generally be handled in bankruptcy. There are two forms of consumer bankruptcy: chapter 7, which is liquidation and discharge; and chapter 13, which is repayment. If you have the ability to pay, a court will likely require chapter 13. The benefit of chapter 13 is that accumulating fines, interest, etc. are stopped, and the debts themselves may be reduced as part of the repayment plan. A chapter 13 repayment plan may be set for 3 to 5 years, depending on your circumstances. Chapter 7 wipes the debts away completely, but requires demonstrating that you have no real ability to repay your debts. You may be required to sell or give back some personal property, particularly vehicles you do not fully own, and any real estate other than the home where you reside. Your personal belongings are usually exempt up to a generous amount that would not require you to sell anything, unless you have expensive jewelry, valuable luxury items, or high-value collectibles. Chapter 7 is intended as a last resort and thus has the most potentially painful consequences.

After taking one of the above approaches to addressing the negative marks on your credit history, in time you may begin (almost) anew. Secured credit cards are often a good place to start, even if they do not represent a particularly good value for money. It takes several years to (re)build a good credit standing, but using credit wisely during this period leads to long-term gains in creditworthiness.

Finally, though I haven’t said much about it thus far, if you happen to have delinquent accounts and are being contacted by creditors, know your rights. Creditors do not have the right to abuse and harass you. Creditors, and particularly third-party collectors who attempt to secure payment on behalf of the original creditor, have limited recourse against you and they by no means have a free hand to pursue the debt any way they wish. If you believe your legal rights have been violated by a debt collection agency or creditor, contact your state attorney general’s office.