What exactly is credit, how does it work, and why is it important? Being able to purchase large items like a home or a car with credit is an important factor that you should consider when thinking of big purchases. Creditworthiness is used to determine whether you are eligible to receive “pay to use” services such as your contract mobile phone or apartment lease.
It’s also used to determine your interest rate on your credit cards and other loans. Some employers may even use your credit rating as a factor when evaluating you for a job! Let’s look at 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 refers to your credit history.
Your credit history is a compendium of all your credit card accounts and loans, covering every financial product you have ever obtained, going back to that very first credit card you obtained in college to get the free t-shirt (remember how cool that was?).
Your credit score is a grading given to lenders to predict how well you can pay your bills in the future. As I have said before, your credit score is a rating given to lenders to predict how well you pay your bills in the future.
If you are new to building credit, you may have a less-than-optimal credit score. However, this can be improved by wisely applying for credit and paying your invoices on time.
How do credit scores work?
So how is credit affected by your credit ratings? In the US there are three major credit bureaus, Equifax, Transunion, and Experian.
Their main task is to gather your credit information from various sources, aggregate it into a report, assign you a credit score based on this method, and make the data available to lenders.
You are assigned a credit rating, a rating that generally falls between 300 and 900, which basically reflects how well you have managed your finances in the past.
The FICO score is the most commonly used scoring method. Factors used to calculate your score are the details of your credit history, including your payment history, outstanding debt, age of credit, new credit/inquiries, and types of credit. 90% of top lenders use FICO scores. Score range: 300 to 850.
The Vantage Score is a German credit rating that primarily competes with the FICO score. The Vantage Score was developed by the three major credit bureaus. Your VantageScore is based on payment history, credit reports, types of accounts, account balances, credit behavior, and available credit. Score range is 300 to 850.
The Beacon score is calculated by Equifax, which is a trademark and proprietary credit bureau. The data used to support the score are Equifax’s records of an individual’s credit. Score range: 280 to 850.
Created by Transunion, a TransUnion company. Contributing to FICO scores, it is used by lenders. Like the Beacon score, lenders use the Empirica score to evaluate creditworthiness. The Empirica score has a range from 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 this high, you will likely be offered a loan at the best possible interest rate.
Paying your bills promptly is a crucial part of how credit functions. It shows your creditworthiness to lenders, and it has a major effect on your credit score. If you are behind on any payments, you should try to catch up as soon as you can. Call your creditors to set up payment plans and establish new payment dates.
It’s also a good idea to build reminders for yourself for all of your expenses to ensure that you don’t miss any payments in the future. Set up all of your regular obligations (with their due dates!) into your spending budget. Another major benefit is the option to automatically sign up for recurring payments.
How can you improve your credit score?
To improve your score, you should review your credit rating.
Find out your credit score
You should be able to answer these questions about your credit at any time. This ensures you will have an easier time obtaining loans, and you will know your credit rating ahead of time. A high credit score and knowledge of your credit file also alert you to scams and identity theft.
It is very important to catch this early because if you catch it too late and your credit has already been damaged, it can be a royal pain in the ass to fix. In the US, you are entitled to receive a free credit report from each of the three credit bureaus once a year. Visit annualcreditreport.com to get your 2019 annual report.
It’s vital to get a copy of your current credit report from all three credit bureaus. After all, you need to know where you stand with your credit.
It is important to be familiar with what has been reported about you to the credit agencies regarding your payment history, how much you owe, your account types, and any late payments or delinquencies.
Pay your bills and loans on time
As stated in point 3 above, this is a must and if you are not able to do this, you should contact your lenders immediately to determine your alternate payment options.
Reduce your overall debt-to-credit ratio
You can pay down your debts and/or pay them off each month. Your total debt load, as well as your percentage of credit utilization, affects your credit score.
If you have a credit card that has a limit of $1,000 and you owe $950 on it, your usage is 95%. High usage can disadvantage you because this indicates to lenders that you are unwilling to pay off what you owe.
Don’t close old accounts
So how is credit worked out for your old accounts? Your credit card accounts make up a critical part of your credit history, so if you maintain existing accounts that indicate you’ve been paying your bills on time consistently, be sure to keep them.
If you have accounts you have paid off, keep them open and make occasional small purchases on them. Fully pay any outstanding balances monthly.
Monitor your credit
Many banks and credit card companies now offer free updated credit scores and daily credit monitoring, which make it easy to stay up-to-date on your credit score. These resources can be helpful to financial account holders.
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 indicates that you are financially responsible and paying it off in full (especially credit cards) will result in fewer expenses each month. This will enable you to concentrate on what matters most, which is building wealth.
Build an emergency fund
Your emergency fund is your backup plan in the event of an emergency. Having one means you won’t be forced to use debt to handle the situation, which will keep your credit utilization low.
Save for retirement
An emergency fund aims to ensure you always have enough savings in case a financial emergency arises. Over the medium to long run, an excellent nest egg for retirement essentially eliminates the need for debt.
Check your credit frequently
Checking your credit report often will alert you to what information is being reported, so you can correct any errors that you discover.
Put on a credit freeze
It’s a good idea to freeze your credit as well. You can prevent identification by scammers by limiting the number of available credit lines. If you will not be applying for a new line of credit or loan soon, it is definitely something to consider.
It is imperative that you do these things over the long term. Establishing good financial habits can help protect you from situations that could affect your credit.
Now that we’ve had some time to go over some methods to enhance your credit and stay healthy, let’s dispel a few of the false impressions people have about their finances. Understanding your pitfalls will enable you to make smart financial decisions.
How does credit work: What are some common credit myths?
There are numerous misconceptions regarding how credit scores work, such as:
1. Paying your cell phone bill builds your credit score
Many people believe that paying for their cell phone bills helps build their credit score. Unfortunately, this is not the case. However, if you get behind on your payments and miss a payment, this can hurt your credit score.
2. Holding a credit card balance is good for your credit
Wrong! Carrying a balance is not a good idea. Not only do you have to pay money, but you will also be paying interest. That means that the cost of whatever you paid for with credit will cost you more money every month that you carry a balance.
You should always pay your credit card bill in full and on time every month to maintain and improve your credit rating.
3. Checking your credit report will not reduce your credit score
If you are seeking loans or lines of credit, you may be receiving difficult queries concerning your credit score.
Exception questions for credit card applications or credit checks can temporarily lower your score, but softer inquiries such as checking your credit score through credit monitoring apps will not affect your score.
4. Once a credit score is bad, it can’t be rebuilt
Maintaining positive credit habits will improve your creditworthiness over time, and you must address each issue on your credit report.
Paying your utility and other debts on time, working with collection agencies to pay off any past due accounts, getting credit counseling or training, etc., are all things that you can do to improve your credit rating.
Learning how credit works benefits you financially
Now that you know how credit works, be sure to use it to your advantage. That means applying for home loans, getting smartphones, renting apartments, or securing business loans (with a strong business plan).
Don’t use it for credit card debt, which, over time, is to your disadvantage. Learn about how to build good credit by signing up for our free course!