In today’s modern world, almost every adult has credit. In fact, credit is so common that some stores no longer accept cash! Throughout your life, you may use credit for everything from everyday purchases to bigger expenses, such as a property or car.
However, many people sign up for their first credit card without fully understanding credit. This can be dangerous because using credit poorly can lead to future high interest rates, additional fees and penalties, and even a weakened credit profile that makes future borrowing more difficult.
Luckily, credit is fairly straightforward; keep reading for a quick, informative rundown on the basics.
What is Credit?
Credit is a financial agreement, bound by a contract, in which a borrower gets something instantly (such as borrowed money, services, or items) with the intent to pay for it at a later date, usually with interest.
Credit can help individuals make purchases now so they can manage cash flow and cover emergencies.
There are two primary forms of credit: revolving credit and installment loans.
Revolving credit gives you access to the same amount of funds monthly, and you can choose to use it or not. You’re only charged interest if you use the credit and fail to pay everything back within the 30-day payment period. Credit cards and lines of credit are two examples of revolving credit.
Installment loans give you a large sum of money upfront to help you pay for a large purchase. In return, you sign a contract agreeing to make equal payments for a specific period to repay the loan’s total plus interest. Mortgages, student loans, auto loans, and personal loans are examples of installment loans.
How Does Credit Work?
Taking out credit is a contractual agreement between a borrower and a lender. Here are the steps you take when applying for and using credit:
- A borrower applies for credit with a lender.
- The lender reviews the applicant’s credit information (credit report and credit score) to determine if they’re approved and at what terms and interest rate. Those with better credit will receive faster approvals and lower interest rates than those with poor credit.
- Once you’re approved, your revolving credit or installment loan will be given to you.
- As you use the credit, you’ll be expected to make payments back to your lender, which may include interest. Failure to make your payments in full and on time can incur interest charges as well as additional fees. In the case of installment loans, if you miss several payments, you may be at risk of having your car or property taken away.
What Matters For Your Credit: Credit Scores and Credit Reports
It’s almost impossible to get new credit without having the lender run a hard inquiry into your credit. When a lender does this, they access your credit report and score to understand if you have “good credit.”
Someone who makes payments on time, has manageable debt levels, and doesn’t overspend will typically have good credit.
Let’s take a closer look at the two factors that impact your credit:
Credit Scores
Most American adults over the age of 18 have a credit score. Your credit score consists of a three-digit number representing your creditworthiness based on your previous financial transactions. The higher your score, indicates to the borrower that you are reliable and trustworthy..
Credit scores range from 300 to 850.
FICO and VantageScore are the primary credit scoring models most American lenders use. Each adult has both a FICO and VantageScore and while they may not be exactly the same, the difference should be small.
The 5 Credit Score Factors
Your credit score is made up of five factors. Each of these five factors carries a different weighted importance to your overall score:
- Payment History (35%): Your ability to make monthly payments on time.
- Amounts Owed (30%): The total amount you’ve borrowed and your credit utilization ratio impact your score.
- Length of Credit History (15%): A long credit history positively impacts your score by giving more data about your overall borrowing behavior.
- Credit Mix (10%): A healthy credit mix of revolving credit and installment loans can help increase your credit score.
- New Credit (10%): Any time you apply for new credit, the lender pulls a hard inquiry into your credit. Each hard inquiry will cause a slight, temporary dip in your score. However, having multiple hard inquiries in a short time can add up and cause a significant drop.
The information for each of these factors is pulled from your credit report.
What is a Good Credit Score?
Most lenders consider a credit score above 670 to be “good.”
More specifically, each credit scoring model specifically outlines the different ranges.
For FICO, the credit ranges are:
- Poor: 300-579
- Fair: 580-669
- Good: 670-739
- Very Good: 740-799
- Exceptional: 800-850
For VantageScore, the credit ranges are:
- Subprime: 300-600
- Near Prime: 601-660
- Prime: 661-780
- Super Prime: 781-850
Credit Reports
The other important piece of your credit is your credit report. Your credit report is a summary of your financial interactions with lenders. It shows a great deal of your previous and current financial history, including your debts, credit score, and payment history. In addition to financial information, credit reports contain information that confirms your identity.
All the information on your credit report is collected from credit card companies, financial institutions, and lenders.
Your credit report should be an accurate snapshot of your financial standing and borrowing habits. Its purpose is to allow lenders to understand how risky a borrower you are.
Most lenders you deal with will report your data to the major credit bureaus so it can be added to your credit report. So, if you pay your bills on time and pay off your debts, this is reported to the credit bureaus. As a result, your credit report will reflect the positive data, and your credit score will improve.
By contrast, if you make late payments, miss payments, or default on loans, all of this can be added to your credit report as “negative items.” Depending on the type of negative line item, it can stay on your credit report for six to 10 years. Some negative items have a more significant impact on your score than others. For example, a single hard inquiry will cause a temporary, small decrease, while a debt in collections can drop your score dramatically.
Why Credit Matters
You probably won’t be able to get through life without needing credit at some point. Credit can open many doors for you, including helping you buy your first home, purchase a car, go to college, and finance a small business. It can also go beyond your finances; employers and prospective landlords sometimes run credit checks.
Poor credit can prevent you from taking major steps forward. It also can mean you can’t get access to easy funds when you need them. Or, if you do get approved, it will be at extremely high interest rates that cost you a fortune.
How to Improve Your Credit
The good news is credit isn’t permanent. No matter how poor your credit is at any point, you can always fix it. You just need to develop healthy financial habits. Some quick ways to improve your credit are:
- Pay all your bills on time.
- Pay down debts.
- Never maxing out your credit cards.
- Avoid applying for too much new credit.
Credit Smarts
Knowing how credit works was the most critical first step to take. Now you know exactly what can improve your credit and what can harm it.
Making smart financial decisions can help improve your credit and open doors throughout your life.
You might also be interested in: Credit Scores & Refinancing a Mortgage: Everything You Need to Know
