Credit is an integral part of building a solid financial future. It determines your ability to get a line of credit in the form of credit cards and loans. It also impacts the cost of borrowing. While good credit can make borrowing a breeze, bad credit can severely restrict your options. Understanding the basics of credit and how it works can help you make the right decisions and pave the way to a smoother financial future.
Here’s everything you need about understanding credit better.
What are the Basics of Credit?
Credit refers to your ability to get a line of credit or to borrow money. When you purchase something with credit, you’re essentially buying things with money you’ve borrowed, with the promise to pay it back by an agreed upon deadline.
A history of making on-time payments consistently helps to build good credit. This matters for a lot of reasons. It sets a good foundation for your financial health and determines whether or not you will be able to access money in the future. It also impacts your interest rates if you need to take a mortgage, vehicle loan, or personal loan. You can keep building on your good credit and getting progressively lower interest rates by making consistent on-time payments.
On the other hand, missing payments or defaulting on your payments damages your credit history. This will make it difficult for you to borrow money or even get a credit card in the future. Even if you do get approved, you’ll end up paying much higher interest rates, which significantly increases the cost of borrowing.
Staying on top of your credit and working towards improving is a smart financial strategy, one that will pay off in the long run. It shows potential lenders that you’re a responsible borrower who is committed to paying your dues on time, which will open up more opportunities for you.
Types Of Credit
There are two main types of credit – installment and revolving credit.
- Installment Credit – With installment credit, the lender extends a fixed amount of credit upfront, and you agree to repay it with interest in regular monthly installments over a specified period. The repayment period could be anywhere from several months to a few years, depending on the type of loan and the amount you borrow. Loans, including student loans, mortgages, auto loans and personal loans, are types of installment credit.
- Revolving Credit – With revolving credit, the funds are not actually disbursed to you. Instead you get a line of credit from a lender, up to a certain limit that the lender sets after evaluating your financial credentials. You borrow what you need as you need it and can borrow up to the credit limit that the lender has specified. You then pay back whatever you’ve borrowed by a fixed date every month. As soon as you pay back what you owe, your credit limit gets reset for the next billing cycle, which is usually one month. Credit cards are the most common example of revolving credit.
Although installment and revolving credit work differently, what matters with both is that the payments are made before the deadline. Paying back what you’ve borrowed on time, every time is the single most aspect of building credit. This is regardless of whether you have installment or revolving credit.
What Is a Credit Report & How Does It Tie In With Your Credit?
A credit report is essentially a record that contains a complete history of your credit activities. This report is created and maintained by credit reporting bureaus. Experian, Equifax, and TransUnion are the three major national credit reporting agencies.
Every time you make a loan repayment or you pay your credit card bill, your lender reports it to the three credit bureaus. The bureaus make a note of the payment details and payment date on your credit report. Your credit report keeps growing as every payment detail gets added to it. In addition to the payment details, credit bureaus also receive reports of other credit activities including new credit accounts you’ve opened and old credit accounts you’ve closed.
Missed payments, accounts sent to collections, bankruptcies, repossessions, and foreclosures also get reported and recorded. This negative information stays on your credit report for at least seven years. Bankruptcies stay on your report for about 10 years.
All of these reported activities are reflected on your credit report and get compiled into what eventually develops into your credit history. Credit bureaus use the details from your credit report to calculate your credit score.
What Is Credit Score?
Your credit score is essentially a numerical representation of the data on your credit report. It is a 3-figure number ranging from 300 to 850, with the numbers representing your creditworthiness. This 3-figure score provides potential lenders a snapshot of your credit health. Positive credit activities and longtime responsible credit management adds points and increase your credit score. On the other hand, every negative credit activity knocks a few points from your credit score, damaging it.
A high score is a quick indication that you manage credit well and are a reliable borrower. You can be trusted to pay back any money you borrow on time. A low score indicates that you do not manage credit well and are an unreliable borrower. It acts as a red flag to lenders and it indicates that you’re more likely to be miss payments.
How Credit Score Is Calculated From Details In Your Credit Report
Although every credit bureau uses a slightly different algorithm to calculate credit scores, they all use five factors into the calculation
Payment history
This has the single biggest impact on your credit score. It accounts for as much as 35% of your total score. Paying your loans and credit cards on time and in full helps to improve your score. The more positive your payment history, the higher your score will be. It is the fastest, and easiest way to establish good credit and increase your credit score. It is also the first things lenders will check when evaluating your loan application as it reflects your ability to make on time payments and avoid default, delinquency or collections.
Credit Utilization Ratio
Credit utilization ratio indicates what percentage of available credit you’re using on your credit card/s. It has the second highest impact on your credit score, accounting for 30% of your total score. Keeping the ratio low, adds points to your score. The lower your credit utilization ratio the higher your score and vice versa. The best way to keep your ratio low and boost your score is by using your credit card sparingly.
Length of credit history
This accounts for 15% of your credit score. It indicates how long you’ve been using credit in general as well as the average age of all your accounts. This includes how long you’ve been using your credit cards as well as how long you’ve been managing debt payments such as student loans, mortgages, vehicle loans and personal loans. Keeping older credit cards open, even if you’re not using them, adds to the length of your credit history, which adds points to your credit score.
Credit mix
Credit mix takes into consideration the different types of credit accounts you manage and how well you manage all of them. It assesses whether you manage only one type or multiple types of credit accounts and whether you make all of the payments on time or you focus on one account at the cost of the others. A healthy credit mix would include a combination credit cards, student loans, and mortgage or other type of loans. It accounts for 10% of your credit score.
New credit
This accounts for another 10% of your score. Every time you apply for a credit card or loan, it triggers a hard credit inquiry on your credit report. Every hard credit inquiry deduct a few points off your credit score. Applying for multiple credit cards or loans within a short period of time could mean you’re in financial distress. This could damage your total score.
Paying attention to each of these factors consistently can help improve your score slowly and steadily.
What Is a Good Credit Score?
As mentioned earlier, credit score is represented as a three-figure number from 300 to 800. When you open your first credit account you start out at the lowest score of 300. With each positive activity you add a few points to the score and keep building on it. Every negative activity knocks points off the score and damages it.
For loan or credit card purposes, credit scores are ranked from poor to excellent. Here’s a snapshot of credit scoring ranking:
- Poor score – 300 to 579
- Fair score – 580 to 669
- Good score – 670 to 739
- Very good score – 740 to 799
- Exceptional score – 800 to 850
It’s a good idea to check your score regularly to determine its trajectory. If your score shows continued improvement you know you’re doing all the right things. If it keeps dropping you may be doing something wrong. Take time to check your credit activities to determine what you’re doing to hurt your score and take steps to correct it.
The good news is bad credit is not a permanent blot on your financial history. You can improve your score by being committed to practicing good credit habits.
Why Credit History & Credit Score Are So Important to Lenders
When lenders loan money or issue a credit card, they want some sort of reassurance that the borrower will pay the money back within the specified time. The only way that they can actually determine what type of borrower you are is by taking a look at your credit history and credit score.
A strong history and good score is reassuring to lenders as it tells them that you will pay back the money you borrow within the promised schedule. When you apply for a loan or a credit card, you’ll get approved easily. As an additional bonus, lenders will also quote a lower interest rate.
On the other hand, lenders will be more hesitant to extend lines of credit to applicants with low scores and a lot of negative entries. You’ll find it more difficult to get approved for a loan or credit card with a poor score as you’ll be seen as a high-risk borrower. And the few lenders who do approve your application will almost certainly quote a higher rate of interest to compensate for the higher risk.
Building good credit is crucial to being able to borrow at a lower rate. It may also make it easier for you to get a job, get approved for a home mortgage, and lower your homeowner’s and vehicle insurance rates.
How To Build Good Credit
Establishing a solid credit history is possible but it takes time, patience, and consistently good financial habits. These here are ways to do to build good credit:
#1. Use credit regularly
It’s impossible for lenders to assess how responsible you are with managing your lines of credit without looking at your credit history. And you can’t establish credit history if you never use credit. Using a credit card is the best way to get started with building your credit score. Taking on a student loan or home mortgage helps to build on that score.
#2. Commit to establishing positive payment history
Whether you’re using a credit card, loans or both, the single most important thing you can do to build credit fast is to make sure that all payments are made in full before the deadline. If you keep forgetting payment due dates, set up auto pay or set reminders so those payments go out on time. No excuses.
#3. Keep your credit utilization low
While credit cards are excellent tools for building credit, the way you use your cards reveals a lot about your financial circumstances. Racking up high balances on your card or spending up to your credit limit regularly could be a sign that you’re financially overextended. The secret to using your credit card to build good credit is to limit your spending to about 30% of your credit limit.
#4. Be smart when opening new accounts
Applying for multiple credit cards or loans within a short period will trigger too many hard credit pulls, pulling your credit score down several points. In general, it’s best to avoid borrowing unless you absolutely need to. You can build credit with just one credit card and one loan.
#5. Check your credit report regularly
Sometimes, credit reports record information inaccurately. Any wrong negative entry can pull your score down for no fault of yours. You are entitled to request one free credit report annually from AnnualCreditReport.com. It’s a good idea to avail of this every year, check all entries. If you come across any mistakes, you can file a dispute with the concerned credit bureau, who will then investigate it and correct the mistake, so your score is reflected correctly.
Start working on your credit now, let College Raptor help. It may seem tedious now but the time and effort you put into the basics of credit now is well worth it. When it’s time to borrow money in the future, you’ll benefit significantly from the easy approval and lower interest rates. Visit our Financial Planner Tool to get started building your college savings plan and building that credit up today.
