Last week I went to a personal finance event at MIT hosted by students. The purpose was to educate seniors who are nearing graduation about personal finance and what it means once you enter the real world. It was a great event, led by recent graduates who answered questions ranging from how to budget to how to negotiate a salary with only an academic record to back you up.
One question that came up that I have overlooked here thus far was a very simple but critical point, "What is my credit report/score and why does it matter?"
The first two parts are pretty straightforward and I'll go over them briefly, but the final point is the most important question. Why does the amount of debt you have and how you use it matter? How does it impact the rest of your life?
I'll take a step back first and define debt. Debt is money that you've borrowed from someone or an institution that you've promised to pay back. That's it. Usually this is in the form of a contract or agreement, and this agreement usually has some stipulations on how long it's going to take for you to pay it back, what the minimum amount that you can pay back in a given month is, and how much interest you are going to be charged for every day that the debt is outstanding.
Three of the largest credit reporting bureaus.
A credit report is basically the report card for all of your outstanding debt. Each of the three major companies, Experian, Equifax, and TransUnion, has a separate report for you. It includes every account that you've opened, when it was opened, how much debt you currently have for that account, the maximum amount of debt you can have for each account, and whether or not you've been paying that debt back as agreed.
A credit score is similar to a GPA for your credit report. It's a numerical value that is used to give a 3-digit summary of your credit report. These scores are unique to each company and vary depending on what information that company has available to it or chooses to include.
Now that those terms have been defined, why does it even matter?
Well to you it shouldn't really matter. You're not a better person than someone else because you have a higher credit score. But it does matter to lenders, the people who will decide whether or not they will lend money to you. To them, a credit report/score tells them how likely they are to get their money back as agreed, based on people with credit histories similar to you in the past. Basically it tells them how much risk they are taking on by lending you money.
An example would be if you had $100 would you be more likely to lend your money to your friend who has a good job, has always paid you back in the past, and usually only spends what he has available; or to a friend who already owes you $300, hasn't paid you back when they originally agreed they would, and has a habit of going on shopping sprees even when they haven't paid their bills? Most people would go for the first one because it's less risky. The banks and other lenders do the same thing.
So keeping your credit report clean and free from any bad marks, such as large amounts of debt and late payments, tells lenders that you are responsible and a low risk. Lenders in turn usually agree to lend you more money and at a lower interest rate. So in the end you pay a lot less for buying a car or home. Let's say a car costs $20,000 and you wanted to take out a loan for that amount. If you have a good credit score, at the end of 5 years, you will have paid the car off and paid a total of $22,645. If you don't have a decent credit score, you could end up paying $24,319 due to the higher interest rate you were given on the loan. That's a difference of over $1,600 for the exact same car solely based on your credit score. And that assumes you even get approved at all. Some places will just simply say 'no' if your credit isn't up to their standards.
Other people check your credit as well, including: home loans, employers, landlords, credit card companies, and numerous other places. It sucks to work so hard to find the perfect home or job and then be denied because they think you are a financially risky person.
If your credit report is not looking so hot, there's still hope. Next I'll be talking about where you can go to get a legitimate free credit report, some of the areas of the report lenders look at the most, and how to fix them (hint: time and paying bills on time).