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What Is Credit and How Does It Work?
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Generally speaking, credit allows you to borrow money now and pay the lender back later — usually with interest. But there’s a lot more to it than that. Having a solid understanding of what credit is and how it works is important because it affects many aspects of your life. Use this guide to learn more about credit so you have the knowledge needed to garner a healthy score.
Here’s what you need to know about credit:
- There are four types of credit: revolving, installment, charge cards and service credit.
- Your credit score tells lenders how responsible you have been with credit.
- Credit scores help determine whether you get approved for more credit, like mortgages or auto loans, and help set your interest rates.
- To build credit, start early, pay on time and don’t overextend yourself.
What are the different types of credit?
There are essentially four different types of credit: revolving, installment, charge cards and service.
- Revolving credit. With revolving credit, you are given no money up front. Instead, you are given an account with a maximum credit limit, and you can use the account to make as many purchases as you want within that limit. You can then choose to pay those purchases off every month or carry the balance — i.e., revolve the debt. If you choose to carry a balance, you will usually be expected to make at least a minimum payment every month. Credit cards are a common example of revolving credit.
- Installment credit. This is when you get a specific amount of money from a creditor and repay the funds — with interest — in regular installments over a specified time period. Mortgages and car loans are both examples of installment credit.
- Charge cards. Charge cards are like credit cards, except they must be paid off in full every month. Because you cannot carry a balance on a charge card, they are not considered revolving credit.
- Service credit. You might not think of your electric bill as credit. But anytime you are provided a service (cellphone, water, cable) for which you are billed later, it falls under the heading of service credit. Most service accounts do not appear on your credit report.
What is a credit score?
Your credit score is a three-digit number that indicates your creditworthiness. Most credit scores fall between 300 and 850, including FICO® Scores.
Not sure how your FICO Score ranks? Here’s a look.
|800 and up||Exceptional|
|740 to 799||Very Good|
|670 to 739||Good|
|580 to 669||Fair|
|Less than 580||Poor|
Don’t panic if your credit score varies among the three national credit reporting agencies — Equifax, Experian and TransUnion. This is completely normal because all creditors do not report to every bureau.
A credit score is influenced by five different factors, including:
- Payment history — 35%
- Amounts owed — 30%
- Length of credit history — 15%
- Credit mix — 10%
- New credit — 10%
These percentages are standard for the general population but can vary slightly from one person to the next.
Why do credit scores matter?
“Credit scores matter because they show that you have the ability to pay your debts on time,” said Eric Matthews, owner of EDM Capital, a wealth management firm based in Phoenix. “If you get a loan and borrow money, banks want to know how trustworthy you are with their dollars.”
Since banks make money on interest rates, they want to lend funds to borrowers who can manage the loan properly and repay their debt on time, he said.
“If you have an 800-plus score, you are the golden child,” Matthews said. “They will leap at the opportunity to lend to you.”
Just as lenders feel confident loaning money to borrowers with a high credit score, they may be hesitant to lend to you if you have a low score, indicating you haven’t paid your debts on time — or at all.
“At the end of the day, you don’t want to be the neighbor that borrows the leaf blower and never returns it,” Matthews said. “You get a bad reputation, and the other neighbors all know that you’re the guy or gal that doesn’t return stuff you borrow.”
When making a major purchase like a house or car, 90% of top lenders will check your FICO Score as part of the loan approval process. Potential lenders use your score not just to decide whether to approve you, but to determine your interest rates.
What’s in my credit report?
If you want to see what sort of information is included on a credit report, you can check out a sample credit report from Experian. Let’s take a closer look at the different elements.
Personal information. This includes your name, Social Security number and any addresses associated with your accounts. This personal data is not factored into any scoring models, but it’s important to make sure it is correct to protect you if you ever need to prove your identity.
Personal statements. You have the option to write personal statements that will appear on your credit report. They stay in place for two years and are visible to anyone with access to the document. For example, if you were briefly unable to pay your bills because of a natural disaster, you might include a statement explaining that.
Potentially negative items. Issues highlighted in this section include late payments, charge-offs (also known as accounts sent to collection) and bankruptcies. However, not all this information is necessarily negative. Some items could be included here so potential creditors have the option to put them under closer scrutiny.
Accounts in good standing. Just as the name suggests, this section contains a list of accounts with a positive status. Since some creditors don’t report to all three bureaus, some of your favorable accounts might not be noted. Accounts reported by creditors will contain up to two years of your monthly balances.
Credit inquiries. Here you’ll find the names of businesses that have requested your credit information. This list can date back a maximum of two years.
6 tips for building good credit
Pay bills on time. Because payment history is the most heavily weighted factor of your credit score, the best thing you can do for your credit score is to pay your bills on time. “The more timely payments you make, the better the score,” said John Pak, a certified financial planner and founder of Otium Advisory Group, a financial planning firm based in Los Angeles. FICO uses three general factors to score the impact of late payments: how recently you made the late payments, how severe they were and how often this happens.
Keep your oldest credit card active and open. If you’re no longer using your first credit card, you’re probably tempted to close it. However, this could negatively impact your length of credit history. Rather than close old cards, simply put them in a drawer or cut them up. This way, you lengthen your credit history without adding to your debt.
Check your credit report and credit score regularly. Keeping a close watch on your credit report can allow you to spot inaccurate information, including fraud, in a timely manner. You’re allowed to check your scores as often as you like without penalty.You’re also able to obtain one free credit report every 12 months from each of the three national credit reporting agencies by visiting AnnualCreditReport.com.
Diversify your credit mix. Since credit mix composes 10% of your FICO Score, having a variety of credit cards, retail accounts, installment loans and finance company accounts can boost your score. However, FICO noted it isn’t necessary to have one of each and advised against opening an account you don’t need.
Don’t overextend yourself. Your credit utilization ratio — the amount of your debt relative to your overall credit limit — is a significant part of your score, so you want to keep it low. Under 30% is what most experts suggest. “Once you use 30% or more of your total credit, your score drops almost immediately,” said Chance Butler, founder of InvestingUnder35, an investments and financial planning firm based in Queen Creek, Ariz. Though keeping your balances low is the best way to maintain a good utilization ratio, you can also call your credit card provider to ask for a raise to your credit limit.
Start early. “Typically a creditor views a seven-plus year history as a great indicator of a low credit risk,” Butler said. “The sooner you can start this clock, the better.” Butler advises parents to help their children open a credit account and manage it properly. “You do not need to pay interest on the card,” Butler said. “You simply have to make one transaction a year and pay it off in full right after.”
The bottom line
Your credit score has a major impact on your life. It’s important to understand what goes into this number because knowing how credit works will allow you to make informed financial decisions. Having a healthy credit score pays off in more ways than one — i.e., the potential to score lower interest rates and obtain higher credit limits — so take your money management seriously.