Credit can set the foundation for your personal finances, but what is credit and how does it work? In school you might learn about basic arithmetic and grammar, but learning about credit? Not so much. Unfortunately, not knowing how credit works may hurt you in the long run. In this beginner’s guide to credit, learn more about credit and how it affects you.
Credit is Borrowed Money
First, let’s get back to basics. You may wonder, “What is credit?”. Credit is money you borrow from a lender that you agree to pay back. For example, you might get credit in the form of a credit card or auto loan and commit to make payments toward the loan once per month.
While credit refers to the money you borrow, there are so many other facets related to it. After all, credit is borrowed money, and lenders want to know you have the ability to pay it back.
The importance of credit scores
So, credit is the money you actually borrow, but how do many lenders decide if you’re worthy of lending to? Through your credit score.
Your credit score is a three-digit number that illustrates your credit health and informs lenders about what type of borrower you are. There are many different credit scoring models out there, but the most popular is the FICO scoring model, which is used in over 90 percent of lending decisions.
FICO credit scores range from 300 to 850 — credit scores toward the lower end may mean you have poor credit, while higher numbers, typically above 700, mean you have a good credit score.
Credit score calculations may seem like a mystery, but they’re actually pretty simple. Here is how FICO determines your credit score:
- Payment history — 35%
- Amounts owed — 30%
- Length of credit history — 15%
- Credit mix — 10%
- New credit — 10%
As you can see, your payment history is very important. Lenders want to know if you can pay back your loans on time.
Additionally, amounts owed — or how much debt you are carrying at any given time, is also important. For example, lenders typically want your credit utilization to be less than 30 percent, so if your credit limit is $1,000 your balance should be less than $300. Your credit utilization shows how much of your available credit you are using, and if you’re using a high percentage of your available credit, it could be a warning sign for lenders.
To keep your credit score in good shape, you want to make your payments on time, every time, and maintain a low balance on your credit cards or other loans. It’s also important to consider keeping certain accounts open to show your length of credit history and keep your new credit to a minimum.
The scoop on credit reports
Your credit score is a numeric value that offers lenders a snapshot of your creditworthiness. Your credit report shows your in-depth credit history. Credit reports are documents that include your credit accounts, personal information like your name, address and Social Security number, credit inquiries and more.
Credit reports are created by credit bureaus, which are also known as credit reporting agencies. There are three national credit bureaus including Experian, TransUnion and Equifax. Though they all offer credit reports, the information may vary as creditors don’t necessarily report all the same info to all three credit bureaus.
As a consumer, you are entitled to your free credit report each year at AnnualCreditReport.com. Your credit report helps inform your credit score, so it’s important to check that all of your information is accurate. If it’s not, you can dispute any errors and get them corrected.
In general, it’s a good idea to check your credit report before applying for any new credit or before making a big change like moving. Regularly checking your credit report can also help you identify any potential instances of identity theft.
Different types of credit
All credit is not the same. There are different types of credit that you can have in your credit portfolio.
- Revolving credit. One type of credit is revolving credit, where the amount owed and amount of credit available depends on the payments made. The most popular type of revolving credit is a credit card. Using a credit card, you can charge a certain amount and either pay the minimum each month or pay it off in full. If you have a credit limit of $1,000 and you pay off your balance in full each month, you’ll have another $1,000 to access the following month.
- Installment loans. This type of credit has a fixed payment each month as well as a fixed repayment period. Some common examples of installment loans include student loans, mortgages and car loans.
Having a mix of revolving credit and installment loans in your credit portfolio can illustrate that you are a responsible borrower. Of course, that doesn’t mean taking on a new loan just to boost your credit. But if you have only student loans (installment loans) in your credit portfolio, getting a credit card (revolving credit) and using it for fixed expenses might be a good idea.
Why credit matters
Managing your credit is more important than you might think. If you miss any payments or take on too much debt — or on the converse, have very little credit history to show — it could affect other areas of your life.
Your credit score and your credit report are used in many different situations and can open or close a lot of doors for you. Having good credit may mean getting approved for better interest rates or getting the green light to move into your dream home. Having poor credit can affect your living situation, employment, and access to loans.
Credit can impact your life in so many ways, which is why becoming educated about credit is an important step in your financial life. To keep your credit health in good shape, be sure to stay on top of payments, only borrow what you can afford and keep your balances low. Additionally, you want to stay vigilant with your accounts and monitor your credit score and credit report regularly.
Do you have any other questions about credit? Let us help!