How Does Credit Work—A Helpful Guide
Updated · Apr 06, 2022
For most people, big investments, like buying a house or starting a business, are impossible without credit.
A good credit score can open doors for you in terms of loans and mortgages. So, if you’re planning a big purchase or venture, you should start working on your credit history as soon as possible.
In this article, we answer a few important questions to help you get started:
- How does credit work?
- How to build a good credit history?
- What is the difference between a credit report and a credit score?
- And more
Read on for detailed explanations.
What Is Credit?
A credit is a loan that you take out from a financial institution and pay back with interest. Normally, borrowers go through a credit check to get approved for a loan.
Lenders look at your credit score and credit report to determine how risky it would be to loan you money.
They obtain this information from credit bureaus, which keep a record of your borrowing history and payment habits.
How Credit Works
When you take out a loan, you agree to the loan terms of the financial institution. You receive a certain amount of money that you need to pay back over an agreed-upon period.
Along with the principal (the initial size of the loan), you also have to pay interest. Banks treat this as a fee for lending you the money. The amount depends on your credit score.
A high credit score means you are a low-risk borrower. This will increase your chances of getting a lower interest rate. A low credit score makes you a high-risk borrower, so you will likely get a higher interest rate.
The length of the loan term also affects the interest. The longer it is, the more you will pay.
That’s the basics of credit explained. Now, let’s see what types of credit are available.
Types of Credit
There are two main options—installment and revolving. Here’s how each type of credit works.
An installment account is a loan in which you borrow a fixed sum and make fixed payments over a predetermined period.
The most common types of installment loans are mortgages, student, personal, and auto loans.
Revolving credit, or an open-ended account, allows you to borrow money repeatedly up to a certain amount.
How does this type of credit work?
To help you understand, we’ll give you an example with the most common type of revolving account—a credit card.
Credit cards allow you to use money that isn’t yours every month as long as you make the minimum monthly payment. If you pay back the whole sum before the due date, there’s no interest.
The bottom line is, unlike installment credit, revolving loans and the repayments are not fixed. They do have some predetermined conditions, though.
Before you apply for a loan of any sort, you have to be familiar with your financial situation. Not just your budget, but your credit history too.
Let’s see how you can check that.
What Is a Credit Report: Definition
A credit report is a document with your credit history prepared by the national credit reporting agencies (credit bureaus).
There are three credit bureaus in the US: Experian, TransUnion, and Equifax. They collect information about borrowers, including their credit, debt, payment history, and whether they've been sued or filed for bankruptcy.
Your report shows your credit history for the past seven years. What’s more, the information is updated every month.
So, if you make a late payment, it will show up on your report the following month and stay there for the next seven years.
So, who tracks all of your credit information?
Apart from you and the credit bureaus, a number of financial institutions can access your report. In fact, they use it to calculate your credit score—a number that represents a borrower's creditworthiness.
It determines whether you get a loan and at what interest rate. Lenders, landlords, employers, and insurance companies use it.
How to Get Your Credit Report
You can get a free copy of your credit report once a year from each of the three credit bureaus. You can do this through AnnualCreditReport.com. This website is the only source of free credit reports authorized by the Federal Trade Commission.
Although it doesn’t contain your credit score, it’s still essential to check it for several reasons:
- Assess your financial situation and check if you need to work on your credit history.
- Review your credit report for accuracy. Make sure all information is correct. This includes everything from your name, address, and Social Security Number to credits in your name. If it’s inaccurate, you can dispute it.
- Checking your credit report regularly will help you identify potential problems early. It’s an important step in identity theft prevention.
What Is a Credit Score?
Your credit score is a measure of how likely you are to repay your debts. It determines whether you get a loan or a credit card and the interest rate.
If you have a low score, it can be difficult to get credit. You may also have to pay a higher security deposit or put down a larger down payment for a house.
How Credit Scores Work
There are several factors that go into calculating your credit score. The most important one is your payment history, or whether you pay your debt and bills on time.
Your credit score is also affected by the amount of debt you have compared to your credit limit, also known as credit utilization rate.
The types of credit you have also play a role. For example, a mortgage is considered a better indicator of reliability than a credit card.
Last but not least comes the length of your credit history. This includes the age of your accounts and for how long you’ve had credit in general.
Each of these factors contributes with a different weight to the measurement. The names of the credit score models used to calculate it are FICO and VantageScore.
Let’s see how each of them works.
Credit scores started in 1989 when FICO introduced the first scoring model.
It is based on five factors, each with a different weight.
- Payment history (35%)
- Amount owed (30%)
- Length of credit history (15%)
- Credit mix (10%)
- New credit (10%)
The FICO score is a number between 300 and 850. If yours is between 670 and 739, it is considered a good result.
Let’s see how credit scoring works with the VantageScore model.
The VantageScore was created in 2006 as an alternative to the FICO score. It uses the same factors but weighs them differently.
But while the FICO score is more widespread, not everyone qualifies for one. You need to have a credit history of at least six months.
The age of your accounts doesn’t matter for VantageScore, as long as you have at least one type of credit in your report.
The VantageScore also ranges from 300 to 850.
Which credit score counts as good? Anything between 661 and 780.
How Do I Check My Credit Score?
As we mentioned, your credit score is not available in your credit report. It is a bit more difficult to obtain it.
How to Work on Your Credit
Not everyone qualifies for a credit score, but you don’t have to borrow money from a financial institution to have one.
The best way to start building a credit history is to get a credit card. If you use it for shopping and pay back everything before the due date, you’ll improve your payment history.
Just remember to pay on time. Also, don’t borrow more than 30% of your credit limit.
You should also try to keep your debt levels low. Having multiple types of credit and open accounts at once could also hurt your score.
If you’re already repaying several credits, you won’t be able to take on much more debt.
Last but not least, you need to check your credit report regularly. Understanding your credit history can help you identify the areas you need to improve.
Plus, that way, you can make sure there are no errors in your report and monitor for potential signs of fraud.
Identity theft protection and credit monitoring services can also help you with that.
Building a good credit score takes time and patience. But these tips will help you get started.
To get a loan with a low interest rate or a credit card, you need a good credit score. But building one takes time, patience, and most importantly, financial literacy.
To help you get started, we answered a few key questions.
How does credit work? Where can you find your credit report? What is a good credit score?
Once you understand the basics, improving your credit history will only be a matter of time.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.