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5 Credit Basics Everyone Should Know

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Strong credit isn’t complicated. In fact, you can build good credit by employing some simple habits and being aware of how credit works.  Credit basics were the topic of a recent Google Hangout hosted by Bank of America and the Khan Academy. Credit.com CEO Ian Cohen was a panelist in the discussion, and he and the other guests outlined some simple concepts everyone should know about credit.

In order to grasp the details, consumers need to understand the basic concept of credit: It’s your financial reputation. As personal finance expert and author Farnoosh Torabi explained during the discussion, your reputation is made up of certain behaviors that help lenders decide if you are a risky customer or not. In short: “Are you going to pay me back?”

There are many ways to show a lender that you are creditworthy, which the panelists discuss in the video below.

1. How Credit Scores Are Calculated

Lenders look at credit scores as risk indicators, and while there are many scoring models, they incorporate these five components of a consumer’s finances:

  • Payment history
  • Debt (balances, available credit and the ratios between them)
  • Seriously negative information, such as defaults, bankruptcy and foreclosure
  • Length of credit history
  • New accounts

In order to maximize your credit score, and look more attractive to lenders, pay your bills on time, avoid debt and keep your debt levels low, take on only debt you can afford, use credit continually (though not excessively) and avoid opening a lot of new accounts in a short period of time.

2. Now Is the Time to Build Credit

Consumers should not put off improving their credit, because credit scores positively reflect long credit histories. Young adults should start establishing credit early as authorized users on parents’ cards and get their own cards when they are eligible and prepared to handle them responsible.

If you haven’t started building credit, start now. Consumers with no credit or bad credit can get secured credit cards and eventually, after keeping up with payments, move on to non-secured cards. And if you are recovering from hard times that have wrecked your credit, look forward at what you can improve: Make a plan to pay down debt, and pay off loans with the highest interest rates first.

3. Good Credit Saves You Money

Having good credit scores helps consumers save money. People with higher credit scores are offered lower interest rates, meaning they pay less for goods in the long run. Good credit stems from strong financial habits that help consumers avoid paying fees or penalties, as well.

4. Don’t Take On Too Much Debt

One of the most important questions a consumer should ask before applying for credit is, “How will I use this?” Make sure you’re not hoping credit will give you a lifestyle you can’t really afford. Financing is a tool to help consumers buy what they can afford by breaking down a large expense into a series of manageable payments. When looking at buying a home, taking out an auto loan or using a credit card, look at the monthly costs, and if they are uncomfortably large, look for less expensive options. A guideline for student loans: If you’re going to graduate with a debt load greater than your expected annual salary, it’s time to consider different options.

5. You Can Check Your Credit for Free

You can’t improve your credit if you don’t know anything about it. Americans are entitled to a free annual credit report from each of the three major credit reporting agencies — Experian, Equifax and TransUnion — and credit scores, which are based on these reports, are available for free from several sources.

Credit.com has a free credit monitoring tool called the Credit Report Card, which consumers can use to check their credit scores every month and analyze the components that make up their scores. That way, they know what to improve in order to raise their scores.

Image: iStock

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  • Greg K.

    I am currently in a bankruptcy state with 2 years to go. What can I do to begin the process of strengthening my credit score. At the present , I am cautiously paying for everything with cash while trying to save money.I realize that I have a long and hard road ahead of me. What do you suggest?

    • http://www.credit.com/ Credit.com Credit Experts

      Greg —

      Congratulations on working to rebuild your credit.

      Have you considered getting a secured credit card? As the name suggests, those cards are secured by a deposit before the card is issued. The card limit is generally the amount on deposit. If you pay off the balance monthly (and keep the balance well under the limit — we recommend using 25% or less), you should begin to see your credit score improve. You’ll find more information here:
      5 Myths About Secured Cards

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