If you want to know how credit works, you’re in the right place.
The concept of credit is nothing new. In fact, we’ve been using credit since the dawn of civilization.
The ancient Mesopotamians used slabs of clay with seals to conduct trade as much as 5,000 years ago. These clay tablets were a valueless instrument that represented banking transactions.
We’ve obviously improved our credit system since then, but the idea remains the same. In this guide, you’ll learn the fundamentals of credit and how it works. Let’s begin.
Here’s how credit works:
What is credit?
Simply put, credit is an IOU. An acknowledgment of a debt. When you use credit, you agree that you will receive something of value now, but will pay it back later with interest.
The most common example of this is a credit card. When you use a credit card, you are given money that must be paid back in full by a specific date.
You can also use credit if you want to buy a house, rent an apartment, purchase a vehicle, and set up various services such as your cellphone and electrical. Employers can even check your credit when you apply for a job.
Basically, credit is everything. It’s how businesses and individuals know whether or not you are a responsible person.
What are the 3 types of credit?
When talking about credit, it’s important to understand that there are different types of credit. Let’s go over each.
Revolving credit allows you to repeatedly borrow money up to a set amount known as your credit limit. You then pay back the money, and the money you pay back becomes available for you to use again.
For example, say you have $10,000 worth of revolving credit and use $1,000 of it. Now you have $9,000 worth of revolving credit remaining. However, when you pay back the $1,000, you’ll now have $10,000 worth of credit to use.
The most popular type of revolving credit are credit cards. You may have also heard of business lines of credit and personal lines of credit. Both are similar to credit cards, except they generally have lower interest rates, making them ideal for large purchases.
Revolving credit is the most common type of credit and will likely make up a bulk of your credit history.
Installment credit is simply a type of loan that you make fixed payments toward, such as a mortgage, car loan, or personal loan.
Unlike revolving credit, which you can continuously use as long as you pay it back, installment credit is only for one-time use. You take out a loan for a fixed amount of dollars, and then agree to pay it back over X amount of months, with X amount of interest.
Once you pay the loan in full, it’s considered paid off. If you want to use the money from the loan again, you’ll have to get a new loan with new terms.
Open account credit can also be referred to as open-end credit or open credit and is the least common type of credit.
Open credit is essentially a combination of revolving credit and installment credit. Think of it as a credit card, except instead of having the option to make minimum payments, you are required to pay off the balance in full each month.
Examples of open credit include the account you have with your gas or electric company, cell phone service, and charge cards.
All of these services allow you to spend “open-endedly,” but you have to pay off the balance in full at the end of the billing period.
What is a credit report?
An easy way to think of your credit reportis to think of a school report card. Your report card showed your parents how well you were performing in all your school subjects.
All your grades were then combined and averaged into a single number called your grade point average (GPA). Get all A’s in all your classes? You get a 4.0 GPA. Get a few B’s and some C’s? Get a 2.5 GPA or something around there.
Your credit report essentially works the same way. All the information from your credit report is taken and used to create your credit score (more on this later).
Your credit score is like your GPA. It’s an average number given to you that represents the overall performance.
If you are continually missing payments on bills and carrying large balances on your credit cards, this will show on your credit report, which will then reflect your credit score. The higher your credit score, the better.
What information is on your credit report?
Your credit report contains information about how you manage (and managed) your credit accounts, as well as other data. This information is broken down into several categories. Let’s go over each.
- Identifying information: This includes your name, past and current addresses, Social Security number, and date of birth. The personal information on your credit report does not affect your credit score, it’s just used to identify you.
- Credit accounts: Whenever you apply for a loan or credit card, lenders and creditors report that information to the credit bureaus. This information is stored in your credit report and includes all your credit cards, account balances, mortgage, student loans, vehicle loans, and personal loans.
- Inquiries: Both soft and hard inquiries will appear on your credit report. Most often, inquiries come when you apply for a credit card and can stay on your credit report for two years.
- Bankruptcies: If you’ve ever filed for bankruptcy, your credit report will likely have that information. It will include details such as the bankruptcy filing date and chapter.
- Collections accounts: If you have any past due bills turned over to a collections agency, this will show up on your credit report.
- Public records: Any records that are available to the public, such as tax liens, court judgments, and bankruptcies, will appear on your credit report.
How is your credit report used?
Generally speaking, your credit report is used by companies like Equifax and TransUnion to create your credit score.
Your credit score is used primarily by banks and other financial institutions to decide if you are a safe borrower. If your credit report has several collections accounts or other negative marks, this will negatively affect your credit score, which will scare off potential lenders.
Your credit report is a big deal. The information on your credit report could be the deciding factor of you getting approved for that mortgage, car loan, or new credit card.
In fact, your credit report could even be used to decide whether or not you get hired for a job. How? Well, let’s say you have several negative marks on your credit report, such as collections, tax liens, and court judgments.
Your potential employer may look at this and conclude that you are not responsible. If you can’t properly manage your bills and credit cards, how could you manage the work required for your job?
What is a credit score?
Your credit score is a 3-digit number generated from your credit report.
As you just learned, your credit report contains information about your financial life. If you are responsible with your credit cards, pay all your bills on time, and avoid too many inquiries, this will show on your credit report, which will then reflect your credit score.
Most often, your credit scorewill fall somewhere in the range of 300 and 850. The higher your credit score, the better.
If you have a 700 or higher credit score, this tells banks and other lenders that you are responsible. They can feel safe lending you money without the fear of you defaulting on your loans.
If you have a lower credit score, say 650 or below, banks and lenders will be a little less likely to give you a loan. This is because you are seen as risky and not responsible.
Your credit score can also affect the interest rates that you get for loans. If you have a higher credit score, interest rates tend to be lower because you are not considered risky. In contrast, if you have a lower credit score, you can expect to receive higher interest rates on credit cards and loans.
Interest rates affect how much extra money you are paying over time, so the lower the interest rate on a loan (such as a mortgage), the better.
How is a credit score calculated?
As briefly mentioned above, your credit score will usually fall somewhere between 300 and 850. But how is this number calculated?
Well, each of the three credit bureaus (Experian, Equifax and TransUnion) has slightly different ways to calculate your credit score. This difference is why you may notice inconsistent scores when checking free credit score sites like Credit Karma.
It’s not that your scores are inconsistent. It’s just that some credit bureaus report specific information that others don’t.
For example, your TransUnion credit score may be a 750, while your Equifax score is 738.
Most credit scores are weighed using the same factors. Some factors carry greater weight than others. These factors include:
- Payment history: Payment history has a high impact on your credit score. If you’ve never missed a bill or credit card payment, you’ll likely have a 100% payment history that will positively impact your credit score.
- Credit utilization: Credit utilization also has a high impact on your credit score. Credit utilization is the percentage of your credit that is being used at any given time. Ideally, you want to stay below 30% utilization. Anything higher will negatively impact your credit score.
- Derogatory marks: Derogatory marks include things like collections accounts, repossessions, and foreclosures. These all have a high impact on your credit score.
- Age of credit history: This factor is self-explanatory. The older your credit history, the better. The age of your credit history has a medium impact on your credit score. If you are new to credit, you won’t have any control over this factor.
- Total accounts: The total number of accounts is a calculation of all the credit accounts you have open, including credit cards, student loans, mortgages, auto loans, and personal loans. This factor has a low impact on your credit score.
- Hard inquiries: Hard inquiries come from things like credit applications and can stay on your credit report for up to 2 years. However, they have a low impact on your credit score because their effects tend to fade over time. In other words, brand new hard inquiries will have the most impact on your credit score, but the impact will lessen after several months.
To give you an exact idea of how your credit score is calculated, reference the table below. Each credit factor has a specific percentage tied to it that indicates how important it is.
For example, your payment history will affect your credit score more than the age of all your credit accounts. The average age of your credit accounts could be 20 years, which is fantastic. However, if you have even one missed payment on your credit report, that could negatively impact your credit score more than your fantastic credit account age.
|Credit factor||Impact %||Range for best credit score|
|Payment history||35%||Between 99% and 100%|
|Credit card utilization||30%||Between 0% and 29%|
|Age of credit history||15%||7+ years|
|Total accounts||10%||11+ accounts (credit cards, loans, etc.)|
|Hard inquiries||10%||Under 2 hard inquiries|
What is a good credit score?
A good credit score is anything above 670. The highest possible score you can get is 850. This is true for both the FICO® Score score and VantageScore.
- Exceptional: 800–850
- Very good: 740–799
- Good: 670–739
- Fair: 580–669
- Poor: 300–579
- Excellent: 781–850
- Good: 661–780
- Fair: 601–660
- Poor: 500–600
- Very poor: 300–499
Anything above 740 is considered good or very good. With this score, you’ll receive the best loan rates and get approved for most credit cards.
How do you check your credit score?
The easiest way to check your credit score is by using a completely free service like Credit Karma. Credit Karma allows you to check your TransUnion and Equifax credit scores at any time for free.
I would personally recommend using Credit Karma over AnnualCreditReport. AnnualCreditReport is dated, and it can take as long as 30 minutes of registering before you can see your credit report. And even then, you can only get a free copy of your report once every year.
If you want to have access to your credit report from all three credit bureaus all year long, sign up for myFICO today!
The primary advantage of AnnualCreditReport.com is that you can see your detailed credit report from all three credit bureaus. Credit Karma will show you your credit score from two credit bureaus, and some of the data from your credit report.
However, if you like to regularly check your credit score, Credit Karma is the way to go. It’s free, and you can check your credit score as much as you want.
Check your credit score completely free
- Check your scores anytime, anywhere, for free
- Get credit report alerts
- Get insights about your score and how to improve it
How do you build your credit score?
Whether you are brand new to credit or simply have bad credit and need to rebuild, building up your credit score will take time and effort.
For starters, you must understand how your credit score is weighed and calculated. We went over this in more detail earlier in this guide, but for your convenience, I’ll briefly go over it again.
Your credit score is generated using five primary factors and weighed accordingly. These include:
- Payment history — 35%
- Credit utilization — 30%
- Average account age — 15%
- Credit mix, or number of accounts — 10%
- Hard inquiries — 10%
Now that you understand what affects your credit score, you can start creating responsible habits to build it.
Here’s the deal: depending on where you are on your credit-building journey may change what steps you should take to build your credit score.
For example, if you have $10,000 worth of credit card debt, you’ll definitely want to pay off that debt first before you begin rebuilding. Trying to rebuild your credit score with such mounting debt would be as useless as a chocolate teapot.
With that said, generally speaking, the steps to building your credit score will be pretty much the same.
- Get a secured credit card. If you have a low credit score or no credit score, you won’t be approved for any real credit cards. Fortunately, many banks and lenders offer secured credit cards, which are easy to be approved for and can be used to build your credit. When you open a secured credit card, you’ll be required to make an initial deposit. That deposit acts as your line of credit. For example, if you deposit $500, you’ll have a $500 line of credit.
- Use credit regularly. If you aren’t using your credit card regularly, it will be difficult to build your credit score because lenders won’t be able to report your usage to the credit bureaus. In fact, some credit scoring systems, such as FICO, require you to have a credit account open for at least six months before it is reported to the credit bureaus. This means if you are brand new to credit, you won’t begin seeing results until after six months of usage.
- Pay your bills on time, all the time. Paying your bills on time is crucial to building and maintaining a good credit score. Because your payment history makes up the largest percentage of your credit score, even a single missed payment can significantly impact your score.
- Keep debts low. High debts increase your credit utilization, which has the second largest impact on your credit score. You want to keep your credit utilization below 30%. Anything above that level will have a significant negative impact on your credit score. For example, if you have a credit card with a credit line of $10,000, don’t ever carry a balance over $3,000.
- Pay outstanding bills. If you have overdue bills, pay them off as soon as possible. While a late bill does hurt your credit score, the more overdue the bill, the worse it gets. For example, bills that are 60 days past due have a larger impact on your credit than bills that are 30 days past due.
- Limit new credit card applications. As a general rule, limit new credit card applications to two every six months. When you apply for a credit card, you receive a hard inquiry on your credit report. This causes your credit score to decrease. Applying for too many cards can have a significant negative impact on your score. Many banks and lenders also see this as a sign of desperation, which is a red flag.
Now that you have a clear understanding of how credit works, you can begin building and maintaining your credit.
Having good credit will open you up to many opportunities, such as having the ability to buy a home, take out a loan for a new business, and even finance a rental property investment.
As long as you follow the principles in this guide, such as paying your bills on time and not maxing out your credit cards, you’ll be in good shape.