How Credit Works: Everything You Need To Know About Credit

Updated on

When it comes to making big purchases like buying a home or financing a business, knowing and understanding your credit is super important! That’s especially true if a certain credit score is required in order to get approved for a loan.

Your creditworthiness is used to determine your interest rate on loans and also your eligibility for pay-to-use services.

Your creditworthiness is used to determine your eligibility for “pay to use” services like your contract 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!

Below are 5 things you need to about building, improving and maintaining your credit:

1. Be familiar with your credit history on your credit report

Your credit score is a part of your credit report, which is based on your credit history.

  • What’s credit history? It’s the history of how (well) you’ve paid your bills in the past. And your credit score is a grading given to you to help lenders predict how well you will pay your bills in the future.

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 and make this information available to your potential lenders. Below is a breakdown of the four main credit scores you may have heard of:

  • FICO – 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.
  • VantageScore – The FICO score’s main competitor. This credit scoring method was created by the three major credit bureaus. Factors used to calculate your VantageScore include payment history, credit utilization, type of account and age, total balances, credit behavior and available credit. Score range: 300 to 850.
  • Beacon Score – Developed by the Equifax credit bureau (trademarked and proprietary) to determine and rank an individual’s creditworthiness. The data used to support the calculation of this score is based on the credit data Equifax has on an individual. Score range: 280 to 850.
  • Empirica Score – Developed by the Transunion credit bureau. It’s a score only provided to lenders and is based on FICO. Just like the Beacon score, lenders use the Empirica score to determine creditworthiness. Score range: 150 to 934.

Did you know that in the US, you are actually entitled to a free credit report from each of the three bureaus once a year? It’s true! Check out 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 regarding your payments, how much you owe, your different account types, and any late payments or delinquencies.

Want to keep closer tabs on your credit? creditkarma.com is another great free resource that provides free weekly updated credit scores and credit reports from the three major credit bureaus as well as daily credit monitoring.

2. Know what your credit score is

What is your credit score? When was the last time you checked your credit? Is everything on your credit report documented accurately? Are all your bills being paid 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. This way you 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. This is very important to catch early because if you catch it too late and your credit has already been damaged, it can be a royal pain in the butt to fix.

3. Know what a good credit score is

The general consensus is that a good credit score is 720 or higher. With a credit score like this, you’ll more than likely be approved for a loan at the best possible interest rate.

Paying your bills on time proves your creditworthiness to lenders and has a huge impact on your credit score. If you are behind on any payments, you should try your best to get caught 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 to make sure you don’t forget to make any payments in future.

Clever Girl Tip: Build all your recurring payments (along with their due dates!) into your budget. Also, consider automating your payments.

4. Know how to improve your credit score

Wondering how to improve your credit score? Try the following tried and true methods:

Pay your bills and loans on time: Paying your bills on time will have a positive impact on your credit score and show creditors and lenders that you are financially responsible. If for any reason you are unable to pay your bills on time be sure to communicate this to them as soon as you can. Many creditors and lenders can help you determine an alternative short-term plan.

Reduce your overall debt-to-credit ratio 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. Let’s say you have a credit card with a limit of $1,000 and you owe $950 on it; your utilization is 95%. This 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.

Don’t close old 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.

Build credit while you save: Another great way to improve your credit is with a platform like Self Lender who offer a Credit Builder account that allows you to save money and build credit at the same time. The credit builder account is a small personal loan secured by a CD. When you’re approved for the loan the funds are placed in an FDIC-insured CD so you don’t have to come up with the deposit up front. Your monthly loan payments are reported to the credit bureaus to establish and build payment history. At the end of the term, you get your money from the CD.

5. How to keep your credit in good standing

Once you finally get to a point where your credit is good, how do you ensure you stay there?

Pay off and avoid debt: It’s easy to get overwhelmed if you have a lot of debt but the good news is that with changed spending habits and re-prioritizing your finances you can pay your debt off and have peace of mind. It’s all about picking a debt repayment method, creating a budget, increasing your income if possible and staying focused on paying off your debt as quickly as possible.

Build an emergency fund: Your emergency fund or emergency savings is to help you weather unplanned life circumstances or emergencies. Having a stash of cash to fall back on when life happens means you can minimize using credit or racking up debt to get through your emergency situation.

Save for retirement: Creating financial security for future yourself is very important. Even if you are only able to make small contributions now, thanks to compound interest, your small, regular retirement savings contributions can grow quickly. There are a variety of ways in which you can start saving for retirement including through an employer-sponsored plan or via a ROTH or traditional IRA.

Check your credit frequently: As mentioned above, you are entitled to a free credit report once a year and you can leverage credit monitoring services to keep your eye on how your credit is doing in between. Set calendar reminders for yourself once a month so you don’t forget to check in on your 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.

***

Remember, you should use credit wisely and to your advantage. That means use it to obtain a home loan, to get a cell phone, to rent your 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.

Leave a Comment

Your email address will not be published. Required fields are marked *