How to Establish, Use, and Protect Your Credit
What You Need to Know
What Lenders Look For
Before creditors lend money, they need to be assured that the funds will
be repaid. In other words, is the prospective borrower creditworthy? To
find out, they ask for various types of information:*
Income & Expenses
Lenders will look at what you earn and your regular expenses, such as
rent, utilities, food, and other ongoing items. The amount left tells
them whether you can afford to take on additional debt.
Do you have assets that can serve as collateral? Lenders will look for
things like bank accounts, insurance, and valuable items such as a house,
if you own one.
How do you manage debt? If you have credit cards or have borrowed money
before, you have a history that shows prospective lenders whether you
are creditworthy by revealing details about the amount of debt you already
have, how many credit cards you have, and whether you make payments on
It's easy to qualify for credit if you have a good credit history, but
what if you have never used credit before? This is a common problem for
people who just started working, those who work in the home, people who
always pay in cash, and those who do not have assets or accounts in their
own names. For them, the first step is to establish a credit history.
How to Establish Credit
Begin by opening individual savings and checking accounts in your name.
Over time, your deposits, withdrawals, and transfers will demonstrate
that you can handle money responsibly.
Applying for a loan is another option, but be aware that this method
of establishing a credit history will cost, since loans require the payment
You could take out a bank loan secured by the funds you have on deposit
or by items you own, such as a car. You could also ask a friend or relative
who has good credit to cosign a loan, which means that he or she shares
liability for the loan with you.
You could also apply for department store and gasoline credit cards,
which generally are easier to obtain than major credit cards. Before you
apply for any credit, however, make sure you understand the terms. For
example, how long is the grace period or the time you have to pay the
current balance in full before finance charges are added? Is there an
annual fee or other fees associated with the credit? If you believe that
you will carry a balance, you need to know how finance charges are calculated.
Patience is important in this process. It takes time to establish credit
and build a record of consistency in making payments to demonstrate your
creditworthiness. And it is much better to go slowly and develop a strong
credit record than to apply for too many credit cards or a loan that is
larger than you can handle.
Start slowly, be cautious, keep track of your overall debt, and pay on
time. Most importantly, remember that credit actually represents real
money and has to be repaid with interest.
Once you have obtained credit, it is necessary to protect it. This means
being careful with your credit, debit, and ATM cards, as well as your
account and personal identification numbers (PIN).
Carry only the cards you expect to use, and keep the others in a safe
place. Maintain a list of account and telephone numbers of the companies
that issued your cards. Then, if the cards are lost or stolen, you can
notify the companies quickly. If your notification is received before
the cards are used, you have no legal responsibility for the bills; if
it is received after the cards are used, your legal responsibility is
$50 for each card.
Be cautious about giving anyone your account numbers, especially over
the telephone when someone calls you. Save sales receipts to compare with
your bill, and when you discard documents with account numbers on them,
be certain that the numbers can't be read.
If you disagree with an item on a bill, you are responsible for notifying
the creditor in writing within 60 days of receiving the bill. You should
include your name, account number, the item you believe is in error, and
the reasons why.
Common Reasons for Denying Credit
Among the most common reasons people are turned down when they apply
for credit are:
- ‘Too little time in current job or at current residence.
- Too much outstanding debt.
- Unreasonable purpose for requesting credit.
- Cosigner cannot take on additional debt liability.
- Errors on applicant's credit report.**
- Strict creditor's standards.
In general, creditworthiness must be determined on the basis of criteria
that relate to your ability and willingness to repay debt. You cannot
be denied credit based on your sex, marital status, race, religion, national
origin, age, or dependence on income from public assistance.
If you are denied credit, the creditor must provide you with a written
statement of the action and your rights, as well as the reason for denial
or how to request the reason. For information on the laws applying to
credit, see "Your
Credit Rights," a Federal Reserve Bank of San Francisco brochure.
Improving Poor Credit
If you have fallen behind in your payments, begin immediately to repair
your credit record. Here's how:
- Face up to the problem. Recognize that you are overextended,
and contact your creditors to see if they will set up a new payment
schedule that you can maintain. In any case, don't ignore your bills.
- Immediately stop purchasing with credit. Take your credit cards
out of your wallet. Store them in a spot that is hard to reach, or even
cut them up.
- Consider consolidating debts. You may find it easier to make
a single payment rather than several. You might also get a lower interest
rate that will make it easier to keep up with payments. Remember that
debt consolidation is not a cure-all. You have to learn to control your
spending to avoid future debt.
- Contact a credit counseling organization. You can obtain referrals
for organizations in your area through the National Foundation for Consumer
Credit, (800) 388-2227.
- Don't expect miracles. Don't believe companies that promise
to fix a poor credit rating quickly and painlessly for a fee. As long
as it is accurate and timely, negative information cannot be removed
from your credit record. The only way to improve a credit record is
to let time pass and establish a record of on-time payment.
Divorce and Credit
Aside from its non-financial effects, divorce can cause problems with
your credit record. The end of a marriage does not erase the debts you
and your former spouse took on as a couple. Even if your former spouse
is ordered by the court to pay debts from the marriage, you can become
liable if they are not paid. Here are a few suggestions to protect your
- Decide how to divide or dispose of property. If necessary, you can
use a mediator to work through this with your former spouse.
- Close or separate joint accounts. Decide with your former spouse
who will be responsible for paying bills, and notify your creditors
of your divorce.
- Establish independent credit, if you do not already have it.
- Make sure bills are paid.
Paying Off a Loan Early
If you are applying for a loan and think you may want to pay it off before
it has run its full term, you should be aware that lenders have several
methods of calculating interest. The method they use affects the amount
you will owe if you decide to pay off early. Since lenders are not required
to disclose which method they use, you may have to ask. Here is a brief
description of the most common interest-calculation methods.
Rule of 78
This method uses tables based on a mathematical formula to determine
how much interest you have paid at any point during a loan. It requires
that you pay more interest at the beginning of a loan when you have the
use of more of the money and that you pay less interest as the debt is
reduced. Since all of your payments are the same in amount, the amount
of your payment that is going toward the principal increases while the
amount going toward interest decreases. State law may mandate the use
of the Rule of 78.
Generally, the longer the term of a loan and the higher the interest
rate, the less favorable the Rule of 78 is to borrowers who wish to pay
off early. However, for loans of less than five years and with interest
lower than 15 percent, the payoff calculated by the Rule of 78 is similar
to that calculated with the actuarial method, described below.
This method is most often used for mortgages and other loans in which
a periodic rate is applied to a declining balance. It does not take into
consideration whether a payment is made before or after the due date.
Late payments are subject to a flat penalty, but interest does not continue
Daily Simple Interest
In this method, a daily periodic rate is applied to an outstanding balance.
Therefore, borrowers benefit by reducing the outstanding balance through
early payments or lump-sum payments, both of which reduce the balance
and the interest due. Under a simple interest system, late payers will
end up owing more.
For More Information
* Creditors obtain much of this information from
your credit report, a computerized profile of your borrowing, charging,
and repayment activities. For information on credit reports, see "Your
Credit Report," a Federal Reserve Bank of San Francisco brochure.
** For information on correcting credit report
errors, see "Your
Credit Report," a brochure published by the Federal Reserve Bank of
This overview was based on materials originally
created by the Federal Reserve Bank of Philadelphia.