Credit 101: Using credit wisely

Think of your credit report as your personal financial report card. This report gives you a three-digit score ranging from 300 to 850 that tells lenders how risky you are as a borrower. Every time you pay your credit card balance, repay a loan, or miss a payment, the credit bureaus may receive a notification, which they use to determine your total score.

A good credit score (690 and above) helps position you as a trustworthy, responsible customer. A low credit score (anything below 630) can have significant implications on your ability to access money and may even result in higher interest rates or down payments because you will be considered a "high-risk" borrower.

You can find out your credit score by requesting a free, online credit report from each of the three national credit bureaus through AnnualCreditReport.com. You are entitled to one free copy a year from each agency, or within 60 days of being rejected for credit, employment, insurance, or rental housing due to bad credit.

The first step to establishing good credit is understanding how your score is calculated. The credit bureaus typically take the following five factors into account:

1. Payment history. Paying your bills on time has the greatest impact on your credit score. 
2. Credit utilization ratio. This is the sum of all your outstanding credit balances (your total debt) divided by your total credit limit. In other words, how much of your total available credit are you currently using. For example, if you have a balance of $1,000 on a card with a $5,000 limit, your credit utilization ratio for that card is 20%. Generally, the lower your utilization ratio, the better.
3. Length of credit history. The longer your credit history, the better, so try to start building credit as early as possible and avoid closing older accounts, if possible.
4. Total open lines of credit and types of credit used. There are several types of loans that influence your credit score. In addition to credit cards, your credit score takes car loans, mortgages, student loans, and several other forms of debt into account.
5. Number of hard credit inquiries. Checking your own credit once a year may not affect your score, but there are a lot of other people who might be requesting a report on your behalf. Every inquiry made by a third party in your name can have a negative impact on your score, so try and keep these to a minimum.

There are several things you can do to maintain or improve your score. Here are some ways to keep your financial report card in good shape:

1. Use credit. While it may seem counterintuitive, avoiding debt would hurt your credit. It’s important to build a credit history in order to maintain a credit score. Consumers who rely mainly on cash or debit cards may find that they don’t have enough of a credit score at all.
2. Avoid late payments. Late payments on anything from credit card bills to car loan payments can cause your credit score to drop and may be noted on your credit report for up to seven years. An easy way to prevent this is by setting up automatic payments for at least the minimum amount due.
3. Keep your credit cards. Canceling a card will decrease the amount of total credit in your name and lower your credit-utilization ratio as a result, even if you have no balance on a card.
4. Don’t apply for too many loans at the same time. Credit institutions record all credit inquiries made in your name. Multiple inquiries within a short amount of time can suggest that you might be "high risk", which may have a negative impact on your score.
5. Make copies. If you know several people will be inquiring about your credit within a short time period (for example, when moving or applying for a loan), offer to send them a recent copy of your credit report instead of having them each make a formal credit inquiry on your behalf.
6. Stay below a 30% credit utilization rate. Keep in mind that your credit score takes your overall credit utilization into account, as well as the credit utilization rate for each individual card.
7. Be cautious when co-signing a loan. If your co-signer defaults on a payment or is late, it will negatively impact on your score.   
8. Review your credit report annually. Many credit reports have mistakes or outdated information that could result in a lower credit score, so make sure to request a report once a year.

Whatever your starting point, don’t underestimate the power of these three digits.It’s never too early to focus on building your credit.

The source of this article, Credit 101: Using Credit Wisely (April 2024), is part of Morgan Stanley’s series The Playbook: Your Guide to Life and Money. Learn more about the Playbook and other resources available to help you navigate various life milestones.

CRC# 3750207 08/2024