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! 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! Given how important your credit is, let's get into how credit works.
What is credit history?
So, what is credit history, and how does it affect your credit? Well, your credit score is a part of your credit report, which is based on your credit history.
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, as I said before, your credit score is a grading given to you to help lenders predict how well you will pay your bills in the future.
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.
How do credit scores work?
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 300–900, that basically reflects how well you’ve managed your credit cards and loans in the past. There are four main credit scores used by these bureaus:
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.
The Vantage Score is 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.
Developed by the Equifax credit bureau (trademarked and proprietary), the Beacon score is used 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.
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.
What is a good credit score?
The general consensus is that a good credit score is 720 or higher. With a credit score like this, you'll more than likely get approval for a loan at the best possible interest rate.
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, 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 to 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.
How can you improve your credit score?
In order to improve your credit score, you need to know your current credit standing. So, what is your credit score? When was the last time you checked your credit? Is everything on your credit report documented accurately? Are you paying all your bills on time? Are you aware of any delinquencies?
Find out your credit score
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. In the US, you are entitled to a free credit report from each of the three bureaus once a year. Check out annualcreditreport.com to get yours.
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.
Pay your bills and loans on time
As mentioned in point 3 above, this is a must and if you are unable to, be sure to communicate with your creditors as soon as possible to determine your alternative payment options.
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.
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
So, how does credit work when it comes to your 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.
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.
How can you 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
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.
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 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.
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 in they occur.
Put on 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. This 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.
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.
Now that we’ve gone over 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.
How does credit work: What are some common credit myths?
There are a number of myths going around about how credit works including:
1. Paying your cell phone bill builds your credit score
Many people think paying their cell phone bills helps build their credit. Unfortunately, it does not. However, if you pay your bill late and become delinquent, it will have a negative impact on your credit score.
2. 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.
3. Checking your credit report will not reduce your credit score
If you are applying for loans or lines of credit, you are most likely getting hard inquiries against 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.
4. 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 credit counseling or coaching, etc., are all steps you can take towards rebuilding your credit.
Learning how credit works benefits you financially
So, now that you know how credit works remember, you should use credit wisely and to your advantage. That means using it to obtain a home loan, get a cell phone, 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. Learn more about building good credit with our free course!