Credit Basics

Why is Credit Important
What Lenders Look For
How Credit Affects Rates
The Difference Between low and high credit risk
Correct Errors on Your Credit Reports
Close Unnecessary Accounts
Track your Spending
Set New Spending Goals
Pay On Time, Every Time
Consider Using Your Home's Equity for Debt Consolidation

Generally speaking, "good credit" means paying your bills on time and maintaining a personal financial profile that helps to make lenders confident that you will make mortgage payments on time. Good credit also means that you are not "overextended" or borrowing so much that you are putting yourself at risk for financial problems.

Good credit makes it easier to get a loan when you need it, and helps you get lower interest rates when you borrow.

Take a few minutes to learn about credit, credit ratings and how to avoid overextending yourself financially.

Why is credit important?

Good credit makes it easier to get loans, credit cards, and better interest rates when you borrow. Credit problems, on the other hand, make it harder to get a loan or lower interest rate often when you could use some help the most.

Unfortunately, credit problems don't go away overnight. Late payments a year or more ago can affect your credit history today. Major problems, like bankruptcy or a loan default, appear on your credit record for years.

What Lenders Look For

Lenders evaluate credit risk, the likelihood that a borrower will make payments on time and pay off the loan. To judge credit risk, lenders typically look at:

Income: Regular and documentable income from earnings, commissions, investments, rental payments and other sources. Lenders look for a steady income from month to month and a stable work history.

Assets: Savings, investments, retirement funds, cars and other valuables that are "liquid" or easily converted into cash.

Liabilities: Debts such as mortgage loans, home equity loans, credit card balances, car loans, student loans and other consumer debt.

Other Financial Information: Situations that could affect payments, such as lawsuits, collection activity, recent bankruptcy or property foreclosure, obligation to pay alimony or child support, or being a co-signer on another loan.

Payment History: Making timely mortgage or rent payments is very important. Paying late just once by 30 days or more can affect both the loan and the interest rate offered you. Late payments on credit cards, car payments and other bills are also factors.

Credit Reports: National credit bureaus collect information and provide reports to home lenders and other creditors. Credit reports include details on credit accounts and information on your payment history.

Debt-to-Income: Monthly debt expenses and income get converted to a debt-to-income ratio. While there isn't a standard, lenders often have a maximum number that they will allow a borrower to have.

All the factors listed above work together to affect a person's credit. That's why people with good income and prompt payment histories but a lot of debt might have trouble getting loans. And why individuals with plenty of income and few debts could also have problems if they're often late paying bills or have not established credit.

But here's the good news. Anyone can improve his or her credit rating over time.

How Credit Affects Rates

Good Credit = Lower Interest Rates

Any time a lender gives a consumer a loan, line of credit or credit card, there is a risk that the borrower may not repay the loan on time or at all. If a borrower doesn't repay the loan or pays late, it costs the lender a great deal of money.

Lenders use your credit history, along with information on salary, assets and debts, to predict how much risk is involved with the repayment of the loan. This is much like insurance companies using your driving history to predict your risk of having an accident.

The Difference Between Low and High Credit Risk

Low Credit Risk

Borrowers with good credit histories, high credit scores, steady income and relatively few debts present a low risk of loss for lenders. So these borrowers often qualify for loans or credit lines with lower interest rates.

High Credit Risk

A borrower who has had credit problems, whose income varies substantially from month to month, or who already owes a lot of money in relation to income poses a higher risk for the lender. In order to offset the potential loss of money if the borrower can't make payments, the lender must charge a higher interest rate on the loan. But over time, a borrower can rebuild a good credit rating in order to take advantage of lower interest rates.

Correct Errors on Your Credit Reports

Credit bureaus may not always have accurate or up-to-date information. If you find mistakes on your reports, write the creditor and the credit bureau.

When you write the creditor, describe the problem clearly and include any documentation you have (such as a copy of a check or a receipt). It's a good idea to send the letter by certified mail so you have a record that you mailed the letter and that it was received.

Send a written explanation to the credit bureau, along with copies of your documentation. Ask the credit bureau to include a brief explanation of your side of the story when furnishing reports to lenders. Both the credit bureau and the creditor are legally required to investigate a credit dispute and report back to you in writing within a reasonable time (usually no more than 30 days).

Close Unnecessary Accounts

If you have a lot of credit accounts, consider closing those you aren't using or don't think you'll need. That helps remove the temptation to overspend. Don't close all your accounts however — you need to have some credit accounts in order to maintain a solid credit history.

Track your Spending

Do you have a good idea of where your money goes on a monthly basis? Most people spend a great deal of money on little extras (fast food, beverages, little treats and splurges) without really being aware of it. Try tracking where all your money goes for a month to get an idea of what you must spend versus what you're actually spending. Remember to factor in an allowance for expenses that aren't monthly, like semi-annual or yearly taxes, auto insurance and maintenance expenses, home maintenance, gifts and vacations.

Set New Spending Goals

Once you know where your money has been going, take charge and establish how you want to spend to meet your goals. Then keep tracking your spending monthly, to make sure your plan is realistic and help reinforce your new spending habits.

Pay On Time, Every Time

Set up a simple system to remind yourself when bills are due. Keep all bills together, in order by the date due, and check them weekly. Or write the dates due for each bill on your calendar, and check your calendar frequently.

Pay monthly bills, or set aside the money, before spending for "extras". If you can't make payments because of a short-term emergency, talk to your creditors before you miss a payment to see if they can help you with reduced or deferred payment schedules.

Consider Using Your Home's Equity for Debt Consolidation

If you've owned your home for a while, you may have equity you can use to pay off high-interest debt with a "cash out" refinance loan or Home Equity Line of Credit. Since home loans can have much lower interest rates than credit cards and other types of loans, you can save a lot of money on interest. Because interest on home loans is often tax-deductible, you may save even more (consult your tax advisor).