Credit Ratings Explained

A credit score is a number between 300 and 850 that lets lenders know if you're a risky or a responsible borrower. This complex number is derived by a number of factors. The credit bureau determines: Do you pay your bills on time? Do you pay your bills at all? Do you have enough credit? Are you approaching your credit limit? Can you manage a diverse credit portfolio? It may sound confusing to calculate, but you can get a copy of your credit report to see what your history says about you. On this report, you should look for a number above 760, which is considered "Good Credit." If your score is in the 600s, you'll want to take steps to achieve a better score. If you're below 600, your access to loan opportunities is already limited.

Why Do Credit Ratings Matter?

In a nutshell, your credit rating lets a loan issuer, a bank, a mortgage company or another lender know how risky you are, as a borrower. This determines where your interest rate is set and how much money you will pay in the long run. In some cases, your credit rating may be so low, lenders will decide not to loan you money at all. They can see if you've paid your bills on time, how often you've missed payments, if you owe child support or have a tax lien against you, and if you've overcharged your limits and tried to settle for less. For you, this little three-digit number could mean $200,000 extra on your mortgage or $2,000 extra on your auto loan. A bad credit rating could get you turned down for credit cards, student loans, small business loans or other lines of credit. A good credit rating means you are a responsible borrower, which is something you can feel proud of -- and something that will save you money.

Tip 1: Pay Your Bills

This cannot be overstated: Not paying your bills on-time is the quickest way to kill your credit rating. According to the Fair Isaac Corp, 35 percent of your overall score is calculated by bill payment activity. You must pay at least the minimum monthly payment listed on your statement and you must pay this on-time. Missing one payment can take off as much as 50-100 points from your score. If you miss an entire month on all your bill payments, you can expect to see your score drop down almost 200 points.

The good news is that the last 12-24 months weigh most heavily when calculating your score, so even if you've had some trouble paying on-time in the past, it's not too late to start improving now. There are many solutions if you have trouble remembering your deadlines. You can start keeping a calendar with due dates written on it or program a reminder in your cell phone a week in advance. You can also set up automatic bill payments from your checking account or dabble with computer programs, like Quicken, to stay on top of your finances. If you find you're always coming up short at that particular time of the month, ask your creditor for a new due date. Most are happy to oblige.

Tip 2: Pay Down Your Debts

The next biggest factor in your credit score (30 percent) is the amount of your balances. On your statement, you should look at your "total available credit" and be sure the actual balance is not more than 25 percent of that amount. So, for example, if you're being offered $5,000, your current balance should never be more than $1,250.

Many consumers get roped into the "minimum monthly payment option," which can keep them spiraling in debt for decades. Here is an illustration: according to MSN Money Magazine, the average household credit card balance is $8,000. The Index Credit Cards list says the average interest rate is at 12.65 percent. Your minimum monthly payment would be around $32, which seems reasonable, but it would take you 109 payments or more than 9 years to pay down this debt! To make matters worse, you will also pay an additional $2,720 in interest charges! Many credit card companies also charge a "transaction fee" of $5/month for every month you are carrying a balance too, so that will tack on another $545 over the long run.

Ideally, financial experts say you should be paying off your balance in full each month, so you don't have to pay the credit card companies an extra dime. However, this is often easier said than done and many of us are already extended well beyond our means. As strange as it may sound, the easiest way out of debt is through hard work: taking a second job or working over-time to bring in more income. You will also need to make some sacrifices -- like eating out less often or possibly selling some possessions on a Website like eBay. Using a debt calculator is a great way to see what you should ideally be paying each month to get rid of your current balance. For instance, to pay off that $8,000 balance this year, you'd need to pay $714/month instead of the suggested $32. During this time, you will save $559 in interest fees.

There are several different strategies for paying off large debts. To start, determine what you can afford to pay by making a list of your fixed expenses (rent/mortgage, utility bills, minimum monthly payments, food, transportation costs) and subtracting these expenses from your monthly household income. Now, pay off all your minimum monthly payments. Then, spend the remaining balance on the highest-interest debt until that card is gone, then aggressively focus on the next card. This is a good method if you're paying thousands extra on interest charges. Or you may also choose the "Debt Snowball Method," which has you pay off the smallest debt first just to cross it off your list and feel that sense of accomplishment. This method works best if you need the motivation or if you have a lot of card balances to tackle. If your debts are insurmountable, you may want to consider debt settlement to consider your debts forgiven at a reduced cost.

Tip 3: Look for Errors

In 2004, a US PIRG report discovered that one in four Americans had serious errors on their credit reports. The result was 25 percent of Americans denied access to new credit or given exorbitant interest rates. Some of these errors include: misspelled names, incorrect addresses, listing the same debt more than once, listing files that were past the statute of limitations, reporting false delinquencies and missing positive information.

Consumers can contact the three credit bureaus -- Experian, TransUnion and Equifax -- to get a free copy of their credit report each year. The Fair and Accurate Credit Transaction Act of 2003 says that you are legally entitled to a free annual credit report from each agency. The official government website to obtain these reports is www.annualcreditreport.com. (Note: Beware of the commercials advertising these reports because they often automatically sign you up for a monthly credit monitoring service, which you must later cancel.)

Once you have access to your credit report, you may dispute any credit inaccuracies. You may do this by writing a letter to the bureau, calling their hotline or simply clicking a "dispute" button online. Once you file your dispute, the credit bureau will investigate and ask your creditors to provide proof that the information is accurate. If they do not respond or do not have proof, the negative information will simply be dropped from your report and your credit rating could shoot up as much as 100 points overnight! Often creditors are so inundated with requests they won't even bother to prove your debt. Be careful not to abuse this privilege, however, or your account may be flagged for "frivolous disputes" and you won't be able to argue legitimate mistakes.

Tip 4: Have a Balanced Credit Portfolio

Having too many credit cards accounts for around 10% of your score, as does having the right kind of accounts. A creditor is looking to see that you have a few different credit accounts -- both unsecured lines (like a credit card) and secured lines (like car loans or a mortgage). The average American has anywhere from five to ten cards in their wallet. However, there is no "magic number" when it comes to the ideal amount of credit. You will simply want to make sure that you have more than one type and that you are not using more than 25 percent of your limit on each. If you have a lot of credit cards that are maxed out or above their limit, you'll appear like a risky, out-of-control borrower. Be aware that closing old accounts is also a bad move because it lowers your total available credit, thus making it appear as though you're spending more of your limit. Instead, keep your accounts open and rotate your activity to keep your portfolio active.

At A Glance: The Breakdown

The breakdown of your credit rating is as follows:

-35 percent: Payment History (This means paying all of your bills on-time every month)
-30 percent: Amounts Owed (This means keeping your balance down to 30 percent of what's been offered)
-15 percent: Length of Credit History (This means keeping old accounts open)
-10 percent: Credit Inquiries (This means not scrambling for every credit offer you can find all at once)
-10 percent: Credit Types (This means having a diverse mix of monthly loans and credit cards)