What is credit, how does credit work, and why is it important? When it comes to making big purchases like buying a home or financing a business, knowing and understanding your credit is super important! Find out all you need to know about credit here!
Your creditworthiness is used to determine your eligibility for “pay to use” services like your cell phone or your apartment rental. It’s also used to determine your interest rate on your credit cards and loans.
Some employers may even use your credit report as a determining factor when considering you for a job! Given how important your credit is, let’s get into how credit works.
What is credit and what makes up your score?
Your credit is essentially your ability to borrow money in the form of a loan or credit card at a specific interest rate based on your past borrowing and payment history. Your credit score is made up of several factors, including history, payments, debt to credit ratio, age of the debt and more.
That said, in order to full answer the question, “how does credit work?”, it’s important to know more about each of these different factors.
Credit history length
Your length of credit history is how long you’ve had credit for. If you’ve had an account open for many years, it’s usually better for your credit score.
It obviously takes time to build up a good credit history length, so this isn’t something you can immediately change. If you have no credit at all, you can start building the history length by opening an account.
Your credit history is a compilation of all credit cards and loans you’ve ever had. All the way back to that first credit card you signed up for in college in order to get the free t-shirt (been there, done that!).
It’s the history of how (well) you’ve paid your bills in the past, and it records the amount of cards you have, how much you owe, etc.
If you are new to building credit, you might have an insufficient credit history. But this can be remedied over time by mindfully applying for credit and paying your bills on time.
Credit mix
There are a lot of types of credit, including credit cards, mortgages, student loans, etc. So, your credit mix is how much of the different types of credit you have.
The Ascent from Motley Fool explains that having a good credit mix means a balance of both revolving and installment credit.
History of payment
History of payment is a very big factor that helps determine your overall credit score. It is how well you’ve paid back your debts over time, and it accounts for 35% of FICO scores as well as being important for VantageScore, claims Forbes.
So, if you’re wondering where to start with building good credit, paying on time is an extremely important thing.
Credit utilization (Debt to credit ratio)
Credit utilization is another very important thing for determining your credit score. It is also known as your debt-to-credit ratio, and it is essentially how much you owe, divided by the amount of available credit you have. Using more than 30% of your available credit can make your score drop.
So you want to be careful not to take on any debt that you don’t need to and pay off your credit cards and loans as soon as possible.
New credit
Any new credit cards or loans can affect your credit. If a hard inquiry (when your credit is checked for a loan or credit card) is made when you apply, it can affect your score.
However, Bankrate explains that new credit may also have a positive impact if it improves your credit mix or utilization.
So it’s important to be aware of how this can impact your score before you apply for anything new.
Two types of credit
So, how does credit work when it comes to the types of credit that exist? There are two main types, called revolving and installment credit. Here are the details.
1. Revolving credit
Revolving credit allows you to continue to borrow money on a revolving basis, even if you are currently paying the money back. The best example of this is a credit card, which allows you to make payments while simultaneously using the card. But be sure to learn how to use credit cards wisely.
Other examples of revolving credit include home equity lines of credit and personal lines of credit.
2. Installment credit
Installment credit is a fixed amount of money that you borrow and then pay back over time. You’ll make payments on it continuously until the amount is paid back. But you will pay back with interest.
A home mortgage is one of the best examples of an installment loan, and there are also student loans and other types of loans. Other examples of installment credit include car loans and personal loans.
How your credit score is calculated
So, how does credit work when it comes to your credit scores? In the US, there are 3 major credit bureaus: Equifax, Transunion, and Experian.
Their main job is to collect your credit information from various sources, aggregate them into a report, assign you a credit score based on their methodology, and make this information available to your potential lenders.
You’re assigned a credit score, a number typically between 300 to around 850. Your credit score basically reflects how well you’ve managed your credit cards and loans in the past. A good credit score is deemed as 700 and above.
There are two main credit scores used by these bureaus:
FICO score
The FICO score is the most popular scoring method. Factors used to calculate your FICO score include payment history, debt owed, age of credit, new credit/inquiries, and types of credit.
90% of the top lenders use FICO scores. Score range: 300 to 850.
Fico scores are extremely important to consider, but there is another main scoring method.
VantageScore
The VantageScore is another scoring model. It was created by the three major credit bureaus.
Factors used to calculate your VantageScore include payment history, credit utilization, type of account and age, and credit behavior. Score range: 300 to 850.
Expert tip: Credit isn’t everything
Your credit score does matter for a lot of things, for you as a borrower, from getting a mortgage to being approved for a new credit card.
However, it’s essential to remember that your credit score is just part of your financial picture. There are other things that matter just as much, like saving, investing, and retirement planning.
If you are trying to build your score and it isn’t where you’d like it to be, don’t worry. Focus on the things you can control by continuing to choose financial wellness, and your credit will eventually improve with this intentional action.
Key tips to build and maintain your credit
Now that you’ve answered how does credit work, let’s focus on the best way to build credit.
Building your credit
It’s a smart idea to try to improve your credit score as much as possible. It can help you getting the best interest rates on loans, credit cards, and many other types of debt.
Employers may even leverage your credit score as part of their background checks depending on the role you’ve applies for. Here’s what to do to make your credit score better.
Understand your current credit standing
In order to improve your credit score, you need to know your current credit standing. This is essentially the starting point when it comes to the best way to build credit.
So, what is your credit score? When was the last time you checked your credit? Is everything on your credit report documented accurately?
Furthermore, are you paying all your bills on time? Are you aware of any delinquencies?
You should be able to answer all of these questions about your credit at any point in time. Then, you’ll have a good idea about your credit status before you apply for any loans.
Knowing your credit score and what is in your credit history will also make you aware of credit fraud or identity theft of your personal information. Then, you can figure out what to do if your identity is stolen.
It is very important to catch this early because if you catch it too late and your credit has already been damaged, it can be a pain to fix.
In the US, you are entitled to a free copy of your credit report from each of the three bureaus once a year, according to USA.gov. Check out your free credit report at annualcreditreport.com.
It’s a good idea to obtain a copy of your current credit report from all three credit bureaus. After all, you want to know where you currently stand with your credit.
You need to understand what has been reported about you to the credit bureaus. That means information regarding your payments, how much you owe, your different account types, and any late payments or delinquencies.
Pay your bills and loans on time
Paying your bills on time is a big part of how credit works. It proves your creditworthiness to lenders and has a huge impact on your credit score.
If you are behind on any payments or have bills piling up, you should try your best to catch up as soon as you can. Call your creditors to create payment plans and set up new payment dates.
It’s also a good idea to set reminders for yourself for all your bills. Then you can make sure you don’t forget to make any payments in the future.
Build all your recurring payments (along with their due dates!) into your budget. Also, consider automating your payments.
Reduce your overall debt-to-credit ratio
You can do this by paying down debts and/or paying them off each month. Your overall debt load, as well as your percentage of credit utilization, affects your credit score. You can calculate your credit card utilization here.
Let’s say you have a credit card with a limit of $1,000, and you owe $950 on it; your utilization is 95%. High utilization can count against you because creditors use it as a gauge to see how likely you are to pay back what you owe.
You can also try to add to your credit limit and pay down debt at the same time to make your debt-to-credit ratio smaller.
Don’t close old accounts
So, how does credit work when it comes to your old credit accounts? Your credit card accounts make up a vital part of your credit history, so if you have accounts that show you’ve been paying your bills on time consistently, you’ll want to keep them as part of your credit history.
If you have accounts you’ve paid off, keep them open and make the occasional small purchase on them. Pay them off in full each month.
Monitor your credit
Many banks and credit card companies now provide free updated credit scores as well as daily credit monitoring. It’s worth looking into these services to stay on top of your credit score.
Maintaining your credit score
Once you finally get to a point where your credit is good, how do you ensure you stay there? By maintaining your score. Here’s how:
Pay off and avoid debt
Paying off debt shows your creditors that you are financially responsible, and avoiding it as a whole (especially credit cards) will give you fewer bills to pay each month. It will also allow you to focus on what really matters – building wealth.
So learn how to pay off credit cards fast and use your debit card for purchases.
Build an emergency fund
Your emergency fund is essentially your backup plan in the event the unplanned occurs. Having one means you won’t have to rely on debt to resolve your situation, which in turn means you can keep your credit utilization ratio low.
Save for retirement
Just like with having an emergency fund, over the long term, saving for retirement reduces and hopefully eliminates any reliance you have on debt. A solid nest egg for your future self means you won’t need to finance the costs of your lifestyle come retirement.
So consider different tips for retirement and start planning.
Check your credit frequently
Checking your credit frequently will inform you of what’s being reported, this way, you can take any necessary actions to rectify inaccuracies if they occur.
Apply a credit freeze
It’s also a good idea to establish a credit freeze that prevents the opening of new lines of credit in your name. It can help protect you from credit fraud. If you are not applying for a new line of credit or loan anytime soon, it’s definitely something to consider.
Find out more about the process if you’re wondering, should I freeze my credit?
These are all things you should be doing over the long term. Establishing good financial habits ensures you avoid scenarios that will impact your credit.
3 Common credit myths
Now that we’ve gone over the question of what is credit, plus some ways to build your credit and stay in good standing, let’s dispel some of the myths people commonly believe about their credit.
Having a thorough understanding of these incorrect assumptions will help you make sound financial choices.
There are a number of myths going around about how credit works, including:
Myth: Holding a credit card balance is good for your credit
Wrong! Carrying a balance isn’t a great idea. Not only will you owe money, but you will also be paying interest.
That means the price of whatever you paid for on credit will cost you more money every month that you carry a balance.
You should strive to pay your credit card bill in full and on time every month to build and protect your credit score.
Myth: Checking your credit report will reduce your credit score
If you are applying for loans or lines of credit, there will likely be hard inquiries made on your credit report.
A hard inquiry for credit card applications or credit checks can cause a temporary dip in your score, but soft inquiries such as checking your credit score through credit monitoring tools will not impact your score.
Myth: Once a credit score is bad, it can’t be rebuilt
Your credit can be rebuilt over time if you focus on developing good credit habits and working through the issues on your credit report.
Things like paying your bills on time and in full, coming to agreements with collection agencies for any accounts that are delinquent, getting consumer credit counseling or coaching, etc., are all steps you can take towards rebuilding your credit.
What is a simple definition of credit?
A simple definition of credit is being able to borrow to pay for things and then pay it back at a later time. So your credit cards and any loans you obtain are all considered credit.
You can use credit for many good things e.g. to purchase an asset like a home that has the potential to appreciate. But that said, because you are borrowing money, it is a potential debt that has to be paid back, so you should use it with caution and with a plan.
What is a good credit score?
The general consensus is that a good credit score is 700 or higher. With a credit score like this, you’ll likely get approval for a loan at a good interest rate. An excellent credit score, on the other hand, is about 800 and higher.
How does credit build up?
Credit builds up over time and with good credit behavior. Paying off your debts on time, keeping accounts open, your credit mix, and other factors can help build up your credit.
It takes time and patience to build your score, so don’t expect overnight results.
However, you can consistently take steps to improve your score and make good money moves.
Is credit the money you owe?
Credit isn’t the money you owe, it’s the amount you can borrow and will need to pay back. Credit, however, has the potential to become money you owe, but only if you use it.
For instance, if you have a credit card that you can spend $5,000 on, then you have $5,000 worth of credit. But if you use some of it, then there is less that you can borrow.
What builds your credit score the most?
Your payment history over time builds your credit score the most. That said, there are many factors that contribute to credit.
FICO suggests keeping credit accounts open, using a low percentage of the credit available to you, and not trying to get too much new credit to start.
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Learning how credit works can benefit you financially!
So, now that you know how does credit work, remember you should use credit wisely and to your advantage. That means using it to obtain a home loan, get a cell phone, sign a lease for an apartment, or for business financing (with a solid business plan).
Don’t use it to rack up credit card debt, which, over the long term, is to your disadvantage. Learn more about building good credit with our free course!
