Owning a credit card is almost a 21st-century rite of passage. And that comes as no surprise – we live, we consume, and we take advantage of lending institutions to be able to get through various milestones in our lives. Owning a car, going on our dream vacation, owning a house – these are some examples of the things we tend to buy now and pay for later, as we are often unable to afford them out of pocket.
For better or for worse, lending institutions are always here to accommodate these needs and desires (if we have a good track record, that is, but more on that later).
However, taking out a loan is one of the most substantial financial decisions a person can make because debt can negatively influence many aspects of your life – it can become burdensome and inhibit your ability to save, among other things. If you find yourself considering a loan, but you also like to put a lot of thought into your personal finance, chances are you want to do your due diligence first.
If that’s the case, this article is for you. We want to empower you to make the best financial decisions you can by helping you navigate the intricacies of loans and credit. For that purpose, we’ll give you an overview of what credit is, define a few key terms like credit score and credit report that play a crucial role in your credit opportunities, and discuss the various types of credit that are available to you.
What is credit?
The term “credit” has been around since… forever, and it has attracted a lot of different uses over time. But even in the Code of Hammurabi, people defined credit as an exchange between a party that doesn’t have money and a party that is willing to lend it.
So, the most prevalent meaning of “credit” is an agreement between a client that borrows money and an institution that provides it.
The borrower (or debtor) accepts to repay the debt at a later date, while the institution (lender or creditor) ensures the funds are available immediately. But why would those who have money lend it to those who don’t? It’s because said agreement obliges borrowers to return more money than what was originally extended to them – no such thing as free lunch. The additional charge is known as interest, and the borrowed sum is called principal.
When you want to purchase something (like a computer, a car, or a trip), but you have no money, you borrow money from a bank to pay for the desired good or service. This is how buying on credit works. And the creditor doesn’t need to be a bank – it can be an insurance company, a department store, or a business partner. The typical example of buying on credit is the use of credit cards. With credit cards, the bank pays the merchant in full and charges you monthly installments through which you repay the bank over time.
Other forms of credit
The term “credit” has been in circulation for a long time and has attracted other meanings too. Keep in mind that “credit” doesn’t always refer to financial or bank credit like a mortgage or car loan. Other types of credit include:
Postponed payment in business
This happens when suppliers agree with business partners that payment will happen once the bill for the company has reached a certain benchmark. For example, a grocery store gets daily delivery of loaves of bread but pays monthly. The bread is “on credit”.
Compensation to unhappy customers
Let’s say a customer buys a product, and they aren’t satisfied with it, so they return it. However, the seller in this scenario doesn’t accept refunds. What the seller (company) may do instead is give the customer credit to be used within their establishment. In other words, some companies have no-refund policies, but instead, allow their customers to use the “credit” from the returned product to get something else. For example, an IT store will let you return a laptop, but instead of refunding you, they will keep the amount you paid for the laptop as credit, which you can use to get something else from the same store.
In accounting, credit is used to record the money that leaves the account. Liability, assets, expenses, or revenue can all increase credit (or money owed to someone).
The main takeaway
While in today’s article we’ll be focusing on credit in the traditional sense, related to credit cards and bank loans, just remember that people can discuss credit with you but refer to the term in a completely different context.
How credit and personal finance work
The concept of using more money than you actually have is very alluring, but it does come with caveats. Apart from the fact that this can significantly impact your financial future, you also have to take into consideration that there are limits to the actual amount of credit that creditors would lend to you. Let’s discuss all the determining factors that go into the lender’s decision of granting you a loan.
How do lenders make sure you pay them back?
Why would any lending institution take your word for it that you will pay back the debt? Well, they don’t. What would happen if you aren’t able to meet your obligation?
Historically, you had to put out tangible assets as collateral (an item that’s pledged to the loaning entity to ensure repayment) to get a bank loan. This was the case a century ago. If you failed to settle the outstanding amount, your creditor would keep the collateral.
Mortgages (basically putting your home up as collateral) work in the same way to this day. The bank takes an interest in the property to “motivate” you to settle your monthly payments regularly.
However, this whole landscape changed with the introduction of credit cards. Debtors (i.e. all of us) got a hefty increase in purchasing power without the need for collateral. What’s the catch? Did someone start distributing free dough? Well, yes and no. This is called unsecured lending, but the banks would never let you play them off one another, so they introduced credit rating (or creditworthiness) for each of their clients.
How do creditors know you are creditworthy?
First things first: what’s creditworthiness? Simply put, it’s an assessment of the likelihood of a debtor repaying the borrowed money. And risk managers got to delve into figures to do this.
What banks did was they started sharing their clients’ payment history with one another to assess the risks. This was done through the establishment of credit bureaus or credit-reporting agencies. Credit bureaus hold your credit history and your reputation for repaying debts. When you approach a creditor, they will check how well you did in the past with these credit-reporting agencies and decide the conditions for the loan based on that information.
“That information” is a record of the financial decisions you’ve made throughout your life. To help you understand it, we’ll go into two important concepts – credit report and credit score.
Before we get started, keep in mind that every time a lending institution approves a loan they face a risk. And those of you who have some experience in leveraging risks know that delving into specifics is the best way to estimate potential damage. This is why detailed credit reports were established, along with credit scores that would quantify your standing.
Credit reports are summaries of financial information tied to your identity.
They include your credit history (up to 10 years for bankruptcies in the US), as well as your current balance.
- If your credit report shows a history of timely back payment on your loans, you have “good credit”. In this case, you become not only eligible but also desirable as an applicant for new credit with even more favorable terms, such as lower interest rates or higher limits.
- If your credit history reveals poor loan management and repayment habits, then you have “bad credit”. As a consequence, when you apply for a loan you will get less favorable treatment (more on this below).
What is in credit reports?
The key data points in credit reports are:
- Credit applications – This covers your borrowing activity, both the loans you’ve received and the loans you‘ve applied for but weren’t approved.
- All your active credit accounts – Yes, all of them. From your credit cards to your car loans and mortgages, it’s all in your credit report. This includes info on the creditor (the bank), the type of credit (revolving credit or installment loan), the date they were opened, along with detailed payment history (balances and account status).
- Closed accounts – Credit information about your closed accounts remains in the credit report for 7 years after you close them.
- Recent inquiries – Who has recently asked to view your credit report? These are credit reviews done by lenders, landlords, and (sometimes) employers.
- Co-signer information – Applies when another account is attached to yours. Typical for young adults and their parents, or between spouses with different credit ratings (one more favorable than the other).
- Public records – Information on bankruptcies, mortgage foreclosures, court judgments, divorces, car repossessions, and property purchases.
- Collection accounts – This includes bills sold to collections. An example is a medical bill that doesn’t show as debt in the original credit report.
- Additional comments – Additional comments serve to provide context to your records. They can be added by yourself or your bank.
This is a short overview of the type of data that is collected on each debtor. Of course, credit reports go into much greater detail. For instance, the open accounts log can be quite extensive and contain info on borrowing limits, current outstanding balances, the amount of debt, recent balance, highest account balance, the minimum required payments, etc.
Personal data and legal rights
Another important part of this record is the personal, identifying information. Since it’s easy to mix up borrowers with similar IDs, these credit records also hold your full name, address (including past addresses), Social Security number, employment info (including past employers), and other relevant information like phone numbers or driver’s license number. This aspect of the registry makes the report attractive for identity theft, so go for a reputable credit bureau.
Major credit reporting agencies provide one free credit report per year because they are obliged to do it by US law. Experian does this, and so does Equifax.
While a credit report is accessible to lending institutions, checking its data on a regular basis is not practical. Hence, the credit score, a quantified representation of the information contained in credit reports, is used by creditors to decide whether you’re creditworthy.
A credit score is a three-digit number designed to identify patterns and potential red flags boiled down to a figure that is easy to use. It saves companies a lot of time and effort.
To crunch all that information into a number, credit bureaus use credit scoring models.
Credit scoring models are systems that calculate your credit score. Different models, such as FICO scores and VantageScore, calculate this using their own methodology, but each of them draws the data from credit reports.
The benefits of a good credit score
A credit score can seriously affect your eligibility for loans.
Individuals with low credit scores are called subprime borrowers. They are considered a greater risk, so lending institutions often charge interest at a higher rate requiring a shorter repayment term and a co-signer.
Conversely, individuals with high credit scores are more creditworthy and may receive a lower interest rate. As a consequence, they will end up paying less interest than subprime borrowers.
A person’s credit score may also determine the size of the deposit they’ll need to be able to pay for a utility or to rent an apartment, for example.
Among the few credit-scoring systems, the one most frequently used is the one developed by the Fair Isaac Corporation, also known as FICO.
How to interpret FICO scores
FICO ranks borrowers on a scale ranging from 300 to 900:
- Excellent: 800 to 850 – These are the most responsible borrowers. To qualify for this group, you must have a long credit history, no late payments, and a good balance on your credit cards. Interest rates on credits for this group are low, and credit is available even if there is no collateral.
- Very Good: 740 to 799 – This credit score is reserved for those that generally keep up with their financial obligations. This group does not exceed their credit card limits and for the most part, they pay back on time.
- Good: 670 to 739 – You can find most US borrowers in this group. The conditions for obtaining a loan are not grim in this category, but they aren’t perfect either. If you are in this group, do your due diligence and research different offers before you commit.
- Fair: 580 to 669 – These are the debtors with dents in their credit history. Nothing too big – stuff like missed payments and such – but enough to limit their access to the most favorable rates. Despite all that, credit is available to these folks.
- Poor: 300 to 579 – Here, you will find individuals that have declared bankruptcy. Creditors are wary of such history, so if you are in this group, you’d better take steps to repair your credit. Unsecured credits are difficult to get and assistance from credit repair companies might be helpful.
What if you don’t have a score yet?
There is such a thing as having a credit score below 300. It’s reserved for bank clients without history and, quite naturally, these are young folks that don’t have credit reports.
Being in this group is very similar to applying for a job. We’re sure you’re familiar with this scenario: the employer wants someone young as long as they have experience. But how do you get experience if no one is willing to give you an opportunity? It’s exactly the same with credit.
We covered that you will get credit card loans as long as you have a good credit history. So, if you’re just applying for your first credit card or loan, take note that your early payment behavior will greatly affect your credit score in the future.
How is credit score calculated?
Not all creditors use the same score threshold for approval. While some will approve unsecured loans for individuals with FICO scores of 740, others won’t. It depends on their scoring model and their risk assessment methodology. However, regardless of the subtle differences, you can rest assured that creditors will base their credit score calculation on the following data:
Payment history (35% of FICO)
This model considers payment history, and late payments will affect the score adversely. The total number of unpaid bills and current debt play a significant role. Worst case scenario – you’ve declared bankruptcy (hopefully not too many).
Total debt (30% of FICO)
This takes into consideration the amounts you owe across the board. It includes credit card balance and the sum of due amounts on your loans.
Credit history (15% of FICO)
Obviously, this only applies if you have one. The longer the credit history, the better. Closed credit card accounts are factored in long after you’ve closed them (10 years), so they can both improve or tank your credit score.
Types of credit (10% of FICO)
This is a review of your past behavior with both revolving and installment credit accounts.
Recent credits (10% of FICO)
Recent credits are not as significant a factor, but if you’re applying for multiple new credits in a short time span, it can raise some flags with most lenders.
Steps to a better credit score
In essence, the same type of financial behavior that contributes to a good credit score will serve to improve your standing if you have bad credit. Those who respect the terms set forth by their credit card issuer or other lenders will enjoy better credit records. And although these metrics change all the time, do your best to accomplish the following:
- Pay your bills on time – We can’t over-stress this point because it’s really important. The sooner you start, the better. Employ whatever system allows you to stay on top of outstanding debt, be it scheduled notifications or something else.
- Avoid closing your accounts – Although closing old credit cards might seem like the easy way out, avoid it at all cost. Late payment of debt sent to a collection agency is better than having debt delinquency (failure to pay a debt) in your credit report.
- Decrease Credit Utilization – This is a measure of using your credit card past its limit. Credit utilization below 30% will help, but you should aim to cover the outstanding balance (i.e. pay as much of the balance on your credit card as possible each month).
- Decrease Credit Applications – Requests for new credits will lower your credit score if they are submitted in a short period of time because it signals to the creditors that you are in financial trouble.
- Track Your Credit Report – You are entitled to at least one free credit report per year. Also, you can make so-called soft inquiries, provided they aren’t done too often. If you have fallen victim to identity theft or your credit report contains errors, make sure they are corrected.
- Ask for Help From Professionals – There are companies that specialize in credit repair that will help you dispute inaccurate credit report information or recommend better practices. Also, there are a lot of other options, some of which are totally free, like an Experian Boost.
Types of credit
Don’t be surprised to find out that your credit report has a different bearing on various credit applications. Although they all follow a particular financial logic, there are differences. And, understandably so, as borrowing money for a car is not the same as securing a six-figure mortgage on a house, primarily because the type of credit is not the same across the board.
This is your typical credit card arrangement. The same amount of debt is available to the client each month, but those that repay on schedule can even get a limit extension. If you have an outstanding balance at the end of the billing cycle (i.e. you haven’t paid the full due amount), interest is added on top of the principal.
Your track record on credit utilization ratio and payment history will play a major role in getting revolving credit. This doesn’t apply exclusively to credit cards, but also to any personal line of credit.
This is a fixed amount of credit, but the debtor has to pay in (usually) monthly installments within a set time frame. Student loans, mortgages, and auto loans are the best examples of this type of credit. The total amount includes interest that is determined in the agreement.
Some prefer this type of debt because as long as you respect the billing date, you can successfully manage the credit. Obviously, it’s easier to get a loan for a car with a bad credit score in comparison to getting a mortgage.
Monthly payments for this type of credit differ each month, but they have to be settled completely. Typical examples are utility bills, also known as service credit. The due amount fluctuates based on what you spend during a particular month (for context, take a look at your electricity bill).
The main takeaway
Establishing responsible financial habits is central to achieving some of your long-term life goals. Employers and landlords are likely to check your credit report, and so are insurance companies. Your credit score can have a great influence over the financial outlook of your spouse or your children – both if it’s positive and if it’s negative. Finally, it can definitely affect the availability of business loans for any companies you are managing.
So, nearly 4,000 words in, and we barely scratched the surface of credit. However, while there’s still a lot to learn, this is a solid introduction to how credit, credit scores, credit reports, and your creditworthiness tie into your personal finance and what opportunities they provide.
What we want you to take away from this article is the following: before you make any decisions, remember: every financial action is going to enter your credit record. This is translated into a credit score which gives the lender a clear picture of your financial history, responsibility, and stability. Before choosing a credit, think of your creditworthiness, the reason you need a loan, the potential risks that come with it, and what it will mean for you in the long run.
It’s also a good idea to check out the different offers made by various companies, as the terms of the offers can vary greatly. In other words, take the time to look for the best time frame and interest rates. A great place to start is various banks’ official websites.
If you’re curious, we encourage you to continue researching to learn more about different credits and credit conditions across the world.
And, of course, feel free to browse through our other resources on personal finance and learn what you can do to improve your financial health.
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Credit cards are a great way to make purchases easily, borrow money conveniently, and sometimes even earn money when you use them. But how does using a credit card work, and why are credit cards used? Here’s everything you need to know about how to use credit cards for dummies. No, we don’t actually think…
Why You Should Pay off Your Debt Aggressively
Too much debt is the number one enemy of achieving your financial goals. Now, debt isn’t always bad — it helps people become homeowners, obtain a college degree, and start businesses. Many of us start out with a “just for emergencies” credit card that can be a lifesaver in true emergencies, provided we don’t let…
Obtaining a Home Loan (and How Mortgages Work)
Most people understand that a mortgage is a type of secured loan that a borrower takes out to pay for a home or another type of real estate property, which serves as the collateral. However, a mortgage can be a complicated debt instrument. The 2008 foreclosure crisis is evidence that borrowers often accept the terms…
How Credit Works (And How to Build It)
Whether you’ve taken out a loan or have a credit card, chances are you’ve used credit at some point in your life. But how, exactly, does credit work? What is credit? Yes, credit is what allows you to borrow money, but it’s also become much more than that. For better or worse, credit is like…
Learning to Use a Credit Card Responsibly
To quote Uncle Ben from Spider-Man, “With great power comes great responsibility.” While comic book writer Stan Lee intended the proverb to apply to the film’s eponymous hero, his words also apply to the power of credit cards. Using one correctly can provide you with unparalleled security, convenience, and creditworthiness. However—and there’s always a however,…
What Are the Different Types of Home Mortgages?
What’s the difference between a fixed-rate mortgage and an adjustable-rate mortgage, or ARM? Which is better? Which one should I get? Here, we will compare fixed-rate and adjustable-rate mortgages (ARMs) and discuss the meanings of other mortgage types: FHA, VA, and jumbo mortgages. We’ll also compare the two most common ways homeowners access home equity…