A borrower's first loan often comes in the form of a credit card. Because these new borrowers are not required to complete any credit education prior to securing their first loan, many are unaware how credit can help or hinder their financial futures. Without this understanding, they risk developing lifelong habits that not only will affect their ability to buy a car and home, but could influence retirement plans.
Your Credit Score
FICO, the Fair Isaac Corporation, evaluates the credit repayment information of millions of Americans. There are three major credit reporting bureaus -- Equifax, Experian and TransUnion -- that collect each consumer's credit-related activity and list it on his credit report. From this data a credit score is calculated. The FICO credit score is the one used by most lenders when evaluating a consumer's creditworthiness. This three-digit credit score helps predict how likely a borrower is to properly repay a loan. The FICO credit score ranges from 350 to a "perfect" score of 850. This score is a snapshot of creditworthiness at a given moment and can rise or fall based on the consumer's credit-related activity.
Mortgages, Employment and Insurance
Lenders, employers and insurers use the FICO score as a risk predictor. Because high scores represent less risk, lenders charge these "prime" borrowers the lowest interest rates. Less interest means lower payments over the life of a loan. Insurance companies use the score in a similar fashion -- lower scores mean higher risk and, therefore, higher premiums. An employer may reject a candidate based on a credit history as well, even though federal legislation prohibits it. Some employers may terminate the employee for bankruptcy or high debts, reasoning that it makes the employee more likely to steal or commit fraud.
Credit Facts and Myths
Although a lot of debt and a poor repayment history affects your credit negatively, the FICO score is only a "snapshot" in time, according to FICO. In other words, it's possible to recover from your mistakes. Late payments and settlements remain on your credit history for seven years. Even bankruptcy, which remains on a credit report for 10 years and does significant damage to your credit score, can be relegated to a bad memory if you behave responsibly afterward. You will always have to report a bankruptcy on a job or loan application, however, and you may be charged higher interest rates as a result.
Improving Your Credit
The long-term maintenance of a good credit score requires understanding the basics behind it. Sixty-five percent of your score is based on paying on time and keeping balances low. Maxing out your credit card -- using all the credit available -- every month hurts your score. Don't use too much credit, and resist the offer to open a credit line at the register. Your credit score may drop when you need it most. Your unsecured debt balances should always be below 50 percent.
Keep a mix of credit. Installment loans, such as home mortgages and car loans, are the greatest help to your credit score, although adding revolving credit, such as credit cards, indicates you can manage different types of credit. Do not necessarily close a line just because you're not using it. Keeping it open helps your debt-to-credit ratio, which is the balance you carry relative to your credit limit, and a low debt-to-credit ratio improves your credit score. Keeping the credit line open also helps your credit longevity, and a longer credit history also helps your credit score.
Unchecked consumption, debt problems and high interest rates could negatively affect your retirement possibilities. Limiting your borrowing now funds your retirement later.
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