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Credit Scores and Reports

How does credit work?

The credit system can be confusing, but all you have to do to keep your credit healthy is maintain good financial habits

Summary

Credit is your borrowing power, and how much you have depends on what’s on your credit report. Here’s what you need to know.

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It’s hard to imagine our financial lives without credit. A lucky minority can buy a vehicle or even a home outright, but most of us have to rely on credit for some of life’s most important purchases.

Plus, it goes even deeper than that. Your credit is considered when you’re applying to rent an apartment or requesting utility services. Sometimes, it’s a part of an employment background check. In the majority of states, car insurance companies also check your credit when generating a quote for you.

See related: Tips for renting an apartment with bad credit

So, what exactly is credit, and how does it work? Read on to find out and learn how to make your credit work to your benefit.

What is credit?

Credit is your ability to borrow money or purchase services or goods based on an agreement to pay back on specific terms. The terms usually include the amount of interest you pay and a payment timeline.

Not all credit accounts work the same, and borrowing terms vary by credit type. There are three main types of credit accounts: revolving credit, installment loans and open credit.

Revolving credit

Revolving credit allows you access to money from a financial institution up to a predetermined limit, Molly Ford-Coates, certified financial planner and CEO of Ford Financial Management, explains.

At the end of each statement period – typically a month – you’re billed for the balance. You need to make at least the minimum payment to avoid fees and damage to your credit. However, if you don’t pay your bill in full, you’ll revolve the balance over the next month and pay interest on it.

“The plus side to this is the customer has the flexibility to choose how much money they borrow each month,” Ford-Coates adds. “This may also be a downside if he or she is not a responsible borrower.”

See related: What is revolving credit?

When used right, this type of account can help you manage your budget and cover unexpected expenses when your emergency fund is running low. However, for longer financial commitments and large purchases, it’s usually a better idea to use installment loans – due to credit cards’ higher interest rates.

The most common examples of revolving credit are credit cards, personal lines of credit and home equity lines of credit (also known as HELOC).

Installment loans

“With most installment loans, money is borrowed and given to the customer upfront,” Ford-Coates explains. “The customer then has to pay it back over a set period of time.”

Interest and any additional fees associated with the loan are also included in each bill.

The purpose of an installment loan is to provide a borrower with an opportunity to finance a purchase they might not be able to fund outright. While installment loan amounts tend to be high, lower interest rates and a regular payments schedule make this kind of loan easier to budget for.

The typical examples of installment loans include auto loans, mortgages, student loans and personal loans. Note that interest rates for personal loans tend to run higher compared to other types of installment credit. However, they can still be a good option for emergency expenses and debt consolidation.

See related: Debt consolidation: 4 options to streamline multiple debts

Open credit

Open credit accounts don’t have a credit limit but require the balance to be paid in full each month. For example, utility accounts have a different balance each month that you need to pay in full to continue using the service.

Charge cards are also considered open credit accounts. They don’t have a preset limit, and the amount you can charge on the card can fluctuate depending on various factors such as your credit score, payment history and others. But whatever you spend, you’re expected to pay off the balance in full each month to avoid significant fees or even account closure.

See related: The difference between charge cards and credit cards

American Express is the only major credit card issuer offering charge cards, namely the Business Platinum Card® from American Express, Business Green Rewards Card from American Express and the Plum Card® from American Express. You can also find charge cards from some individual merchants.

What is a credit report?

Creditors, including merchants, lenders and service providers, define terms on which to offer you credit by assessing your creditworthiness. To put it simply, the better your credit history is, the better your chances for credit approval on favorable terms.

Your credit history is reflected on your credit report. It is a record of how you manage your credit prepared by a credit bureau. There are three major credit bureaus – Experian, Equifax and TransUnion – which is why you have three credit reports.

See related: The 3 national credit bureaus: How Equifax, Experian and TransUnion work

Your credit reports contain information, such as:

  • Credit accounts – This includes all of your debt reported by lenders and details associated with it: payment history, outstanding balances and the dates your accounts were open or closed.
  • Inquiries – Each time someone accesses your credit report, it triggers an inquiry. It can be a hard inquiry that happens when you apply for credit or a soft inquiry that can be recorded when someone checks your credit to verify information.
  • Personal information – This includes your name, address and employers you mention on your credit applications.
  • Public records – Your credit reports can also have information on bankruptcies.

See related: Credit report sample: How to read, understand a credit report

What is a credit score?

The information on your accounts and inquiries in your credit report is used to calculate your credit scores. A credit score is a three-digit number that reflects a borrower’s ability to repay debt.

“For anyone thinking of using credit, knowing your credit score is essential,” Andy Mardock, certified financial planner and president of ViviFi Planning, says. “A lower score may lead to a higher interest rate on your loan and potentially thousands of dollars in additional interest over your lifetime.”

You have multiple credit scores – not only because they are generated based on three different reports, but also due to the fact there are numerous scoring models.

FICO and VantageScore are two leaders in the credit scoring industry, and FICO 8 is the most widely used scoring model. You might notice your VantageScore and FICO scores are different from each other. This often happens because they treat credit data differently when generating scores.

“Not all credit scores are created equal,” Mardock explains. “In fact, according to the Consumer Financial Protection Bureau, Fair Isaac Corporation – which is the developer of the commonly used FICO score – has offered over 60 different credit scores since 2011!”

See related: My credit score is 776 – and 815 – and 828?!

However, both the base FICO scores and the latest versions of VantageScore use the same 300-to-850 score range.

Credit ratingFICO ScoreVantageScore
Very poor300-579300-499
Poor580-669500-600
Fair670-739601-660
Good740-799661-780
Excellent800-850781-850

On top of that, FICO also offers industry-specific versions. For instance, auto lenders commonly use FICO Auto Score 8 and credit card issuers FICO Bankcard Score 8.

See related: Educational credit scores are not the same as FICO scores

How to make credit work for you

The complexity of the credit scoring system can be overwhelming. Fortunately, no matter which scoring model your lenders are using, the steps you can take to improve your credit standing remain the same.

See related: 10 tips to improve your credit score in 2020

Terry Griffin, senior vice president of product and marketing for Global Consumer Solutions at Equifax, says there are a few things that consumers can focus on to maintain their credit health.

“The first is paying bills on time, every time,” she insists.

Payment history is the most critical factor in credit scoring. Even one 30-day late credit card payment can weigh your scores down significantly – that’s why it’s crucial to stick to your payment schedule.

“If you are unable to do so, speak to your lenders or creditors and see if any assistance is available,” Griffin suggests. “It is important to contact them first to let them know you are impacted and quickly work out payment details. Be sure to confirm this information in writing and keep a copy for your records.”

Another essential component of your credit scores is the credit utilization ratio, or how much available credit you use expressed in a percentage. To calculate it, add your credit card balances and divide that amount by your overall credit limit. You want to keep this number under 30% – the lower, the better for your credit.

“Keeping this percentage low shows lenders that you can manage your credit responsibly without spending outside of your means,” Griffin explains.

See related: The factors of a FICO credit score

  • Keep your credit cards open. This will help your credit utilization ratio, as well as the length of your credit history. Lenders like to see your older accounts because it demonstrates your experience managing debt.
  • If you’re not happy with your credit card, before closing it consider contacting your issuer to upgrade or downgrade it first.
  • Avoid applying for credit too often. It may signal to lenders that you’re in financial trouble and create too many hard inquiries on your credit report.
  • Finally, make sure to keep an eye on your credit reports.

“Routinely check scores and reports to make sure you know where your credit stands and monitor for inconsistencies,” Griffin says. “Continue to monitor your credit reports regularly to ensure what’s being reported by lenders and creditors is accurate and complete.”

If you notice any accounts or inquiries that don’t belong in your report, it might be a sign of fraud. In that case, take the necessary steps to protect your credit and dispute inaccurate entries.

See related: How to dispute and fix credit report errors

Bottom line

Credit might be confusing at times, but maintaining good financial habits always helps. Take care of your credit health, and you can reap all the benefits that come with good credit, be it a lower mortgage interest rate or the rewards card that you’ve always wanted.

Editorial Disclaimer

The editorial content on this page is based solely on the objective assessment of our writers and is not driven by advertising dollars. It has not been provided or commissioned by the credit card issuers. However, we may receive compensation when you click on links to products from our partners.

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