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An Essential Guide to How Credit Works

Credit is an agreement you have with a lender to obtain goods or services that you pay for at a later date under agreed upon terms. For example, if you get a loan, the lender will give you the money and you will have to repay that loan over time along with interest and possibly other fees.

Credit can also refer to your credit history, which lenders typically consider when determining whether to offer a loan, credit card or similar product. To improve your chances of getting approved for credit at a favorable rate, it's essential to have a good credit history.

What Are the Types of Credit Accounts?

There are two primary types of credit accounts you may come across, depending on the situation and your needs: installment and revolving.

Installment Credit

Installment credit involves a lender extending an amount of credit upfront, and you agreeing to repay the debt in regular installments over a fixed period. Most loans, including mortgages, auto loans, student loans and personal loans, are considered installment credit.

Depending on the type of loan, the repayment period with installment credit can range from months to several years or even decades. And while payments may not be fixed for the life of the loan, especially when a variable interest rate is involved, you'll typically always know when the loan will be repaid in full.

Revolving Credit

Revolving credit allows consumers to borrow money using a line of credit when they need it, rather than getting it all in the beginning. You can typically borrow up to a certain limit, but once you pay down some or all of the debt you've incurred, you can re-borrow up to that same limit, repeating the process over and over again.

Credit cards are the most popular form of revolving credit, although lines of credit also fall into this category. Unlike installment credit, revolving credit doesn't have a set repayment period. And if you have no debt outstanding at the moment, you aren't required to make any payments.

That said, revolving credit can become expensive if you carry a balance over time and make just the minimum required payments.

What Is a Credit Report?

A credit report contains a history of your dealings with credit. You have three credit reports, one from each of the three national credit reporting agencies: Experian, Equifax and TransUnion.

Your credit report lists all of the accounts you've opened and closed in the recent past, along with how you've managed each. For example, if you've missed a payment or had an account sent to collections, it will show up on your credit report.

Your credit report also lists other records, including bankruptcies, foreclosures, repossessions and other information that shows potential red flags to lenders. At the same time, on-time payments and longstanding responsible credit use will also be reflected in your report.

Finally, your credit report lists other basic information, including your name, including aliases and misspellings reported by creditors; your birth date; Social Security number; current and past addresses; and recent inquiries that creditors have made to view your report.

How Does Credit Reporting Work?

The national credit reporting agencies collect information from lenders who report it. For example, if you have a credit card, it's likely that your card's issuer reports your account activity to one or more credit reporting agencies once a month.

The agencies then collect and organize the information into tradelines, which is a term used to describe individual credit accounts. Depending on the type of credit, you may see several different pieces of data, including your recent payment history, monthly payment, balance, original loan amount and more.

It's important to note that financial institutions aren't legally required to report account information to the credit reporting agencies. As a result, not all credit activity helps improve your credit history. Most banks, credit unions and other lenders, however, report to the agencies regularly.

How Do I Get My Credit Report?

U.S. consumers have the legal right to get one free copy of their credit report from each of the credit reporting agencies every 12 months. You can request your free copy at AnnualCreditReport.com.

If you want regular access, you can typically get it from a free or paid service. For example, Experian offers free credit report access that's updated every 30 days on sign in, allowing you to track changes over short periods of time.

What Is a Credit Score?

Your credit score is a numerical representation of the information that can be found on your credit report. It provides you and others with a snapshot of your overall credit health.

While there are many different types of credit scores, the most widely used scoring model is the FICO® Score*, which has a range of 300 to 850. In general, the higher your credit score, the more responsible you've been with credit.

How Is a Credit Score Calculated?

The FICO® Score is based on five different factors:

  • Payment history (35%): This component shows your ability to make on-time payments and avoid delinquent and collection accounts. The more positive your payment history, the better your score.
  • Amount owed (30%): This factor includes the total amount you owe, as well as your credit utilization ratio, which is the percentage of available credit you're using on each credit card, as well as across all of your credit card accounts. The lower your credit card balances relative to their limits, the better it is for your credit score.
  • Length of credit history (15%): This element takes into account both how long you've been using credit in general and the average age of all your accounts. As a result, avoiding unnecessary borrowing and using credit over time are both good things.
  • Credit mix (10%): This credit factor considers the different types of credit accounts you have, such as credit cards, student loans, mortgage loans, auto loans and more. In general, though, your credit mix won't affect your score much unless your credit report doesn't have a lot of other information to use to calculate your score.
  • New credit (10%): Every time you apply for credit and a creditor runs a hard inquiry on your report, it could knock a few points off your credit score. If you apply for multiple credit accounts in a short period, it could be a red flag to potential lenders.

Depending on where your credit score stands, these are the factors you should examine to determine what needs to be addressed to improve your credit history.

Another credit score you might see around but which isn't as popular as the FICO® Score is the VantageScore®. This scoring model includes many of the same factors but may weight them differently. As a result, your FICO® Score and VantageScore may often be in the same ballpark.

What Is a Good Credit Score?

A good credit score can open a lot of opportunities when it comes to getting credit. Whether you're looking at a FICO® Score or a VantageScore, however, what's considered a good credit score can differ. Here are the ranges for each:

FICO® Score

  • Exceptional: 800 to 850
  • Very good: 740: to 799
  • Good: 670 to 739
  • Fair: 580 to 669
  • Poor: 300 to 579

VantageScore

  • Excellent: 781 to 850
  • Good: 661 to 780
  • Fair: 601 to 660
  • Poor: 500 to 600
  • Very poor: 300 to 499

If you check your credit score and see that it's not quite in the good range or above, consider taking some time to work on improving it before you apply for credit next.

How Do I Check My Credit Score?

There are several ways to check your credit score. For example, you can check your FICO® Score for free through Experian or get it from another website that offers free access to your score. Just keep in mind that what you get may not necessarily be the same score lenders use.

Another way to check your credit score is through one of your lenders. Many banks, credit unions and other financial institutions provide customers with free access to view their credit score. Also, if you're working with a credit counseling agency, you may be able to check it through your counselor.

Why Is Credit Important?

For most consumers, building a solid credit history is an important step in establishing their financial security. Not only is credit important to borrowing at favorable rates, but it can also help you get a job, get into an apartment, lower your auto and homeowner's insurance rates, avoid a deposit on a utility agreement, and more.

As you manage your credit wisely, you build overall financial health that can help you achieve your goals. Keeping your credit utilization low, for example, frees up money you can use to put toward saving for a down payment on a car or a home, your retirement, or your child's college tuition. A good credit score will also save you money on loans you take out, again leaving more money available to help you get on strong financial footing.

So whether or not you plan to borrow money anytime soon, it's a good idea to have a good credit score.

How to Build Credit

Establishing a solid credit history can take time, effort and a lot of patience. Fortunately, however, knowing what goes into your credit score can give you ideas on how to build credit. Ideas include:

  • Use credit regularly: It can be difficult for lenders to know how responsible you are with credit if you never use it. In fact, FICO® requires that you have credit-related activity in the past six months to even qualify for a score.
  • Establish a positive payment history: Making your payments on time every month is essential to building credit, so make that a goal. Also, if you've fallen behind on some accounts, try to get caught up as quickly as possible.
  • Keep your credit card balances low: Credit cards are excellent tools for building credit because as long as you pay off your bills on time and in full each month, you can establish a history without ever paying interest. But if you rack up a high balance, it could be a sign that you're overextended financially. Even if your credit limit is only a few hundred dollars, try to keep your utilization rate as low as possible.
  • Borrow wisely: Applying for multiple loans or credit cards in a short period can hurt your credit, and taking on too much debt can make it more difficult to keep up with your payments. As a result, it's a good idea to avoid borrowing unless you absolutely need to. And before you apply, make sure you can afford the monthly payments associated with the new account.
  • Keep track of your credit score and reports: It's a good idea to check your credit score and reports regularly to make sure everything is running smoothly. If you notice a sudden drop in your score, it's best to address it sooner than later. And if you see an account show up on your credit report that you don't recognize, it could be erroneous or fraudulent. If so, you can dispute the tradeline with the credit reporting agencies.

It's Never too Late to Work on Your Credit

The best time to start working on building your credit is now. Regardless of how many negative items you have on your credit report, their impact can diminish over time as you add new, positive information. And while it may take time to get to where you want to be, improving your credit score could save you thousands of dollars on future credit opportunities.


Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.

This article was originally published on August 4, 2016, and has been updated.

*Credit score calculated based on FICO® Score 8 model. Your lender or insurer may use a different FICO® Score than FICO® Score 8, or another type of credit score altogether. Learn more.

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