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 oil in the engine of the modern economy—things just don’t run as smoothly without it.
Your credit usage could affect your insurance rates, ability to rent an apartment, and much more. Here’s a bit more about what credit is, how you can improve your credit, and why it is so important.
What is credit?
The dictionary definition of credit is: “The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.”
In its simplest form, credit is a contract between a buyer (the creditee) and seller (the creditor) that stipulates the buyer will pay for a purchase at a later date.
Imagine the classic “bar tab” with which a bartender allows a regular patron to order drinks over for a period of time and then settle up at the end of the night, week or month. The customer gets their drinks now and pays the bar later. The bartender trusts the customer either because 1) they know them personally or 2) because the customer has given the bartender something of value such as a driver’s license or debit card (known as collateral).
The bar tab example clearly illustrates how credit works, but it omits an important part of credit, interest.
Regardless of how well they trust the credited, most creditors do not extend credit without getting something in return. (In legal language, this is called consideration). For something small, like a bar tab, the consideration might be as simple as making it easier for a customer to order drinks, leading to more business for the bar. But when the stakes get higher, the most common kind of consideration in credit contracts is interest.
Interest is money the creditee pays the creditor on a regular schedule for the privilege of borrowing money. Interest is calculated based upon the amount of money borrowed and the amount of time it takes the creditee to repay. Interest is expressed as a percentage rate over a period of time (most often, annual). For example, a 5% annual percentage rate (APR) means that a borrower will pay 5% of the amount owed per year.
Although a seller can extend credit directly to a buyer, in the real world it is more common for a lender (usually a bank) to serve as an intermediary between the seller and the buyer. If you pay for something at a store with a credit card, your credit card issuer is loaning you the money and then immediately pays the store. If you buy a car with an auto loan, a finance company pays the car dealership and then collects the money from you.
Sellers love lenders because they make it easier to sell things without taking on the risk of lending money to customers. Lenders love being in the credit business because collecting interest is highly profitable. Lenders don’t have to go through the hassle and expense of making a product, they simply lend money and collect interest. Customers like credit because it enables them to afford more expensive things by paying for them over time.
When used wisely, credit is a powerful financial tool that helps all parties. But like all things powerful, credit can be misused and create trouble — for borrowers and creditors alike.
The history of credit
Credit has likely existed as long as people have been trading things. The Bible, for example, is full of references to lending and borrowing. Take this example from Proverbs 22:7:
The rich rules over the poor, and the borrower is the slave of the lender.
In the recent history of the United States, however, credit has become an almost unavoidable part of life.
For centuries, credit was a necessarily personal thing. If you wanted to borrow money from a bank or start a tab with a business, you would need to provide personal references. The banker or businessperson would want to know who they were dealing with.
But as the United States grew and the railroads made it easier for people to move from one city to the next, not everybody who needed credit could produce one or more personal references. The late 1800s saw the creation of credit reporting agencies. For example, Equifax — one of the three major credit reporting bureaus today — got its start at a grocery store when the owner began to keep a list of creditworthy customers. He would then sell this list to other retailers so they could offer credit to qualified customers, even if they hadn’t yet done business together.
The role of credit in the United States became even more important following the Great Depression. As part of FDR’s “New Deal”, the U.S. government began guaranteeing mortgages. This not only encouraged banks to start lending again following the Depression, but it unlocked the possibility of homeownership for millions of Americans.
Prior to government-backed mortgages, banks would only lend up to 50% of a home’s value and require repaying in 10 years. Imagine wanting to buy a $300,000 home, needing to put $150,000 down and still having a $2,000 monthly mortgage payment. Following the New Deal, banks would start lending up to 80% of the home’s value over terms of up to 30 years. You could now buy the same house with just $60,000 down and a monthly payment of less than $1,500.
The rise of credit cards in the 1980s was another important credit milestone in America. Consumers can now walk around with a line of credit in their pocket that can be used to buy virtually anything — whether they have the money for it or not. Merchants. no longer need to worry about extending credit themselves — banks issuing credit cards take all the risk!
For better or worse, credit is part of the fiber of our modern economy. A person’s creditworthiness is often a factor when leasing an apartment or even applying for a job.
Your credit history
Your credit history includes all the credit cards and loans you have ever been legally responsible for, along with any debts you’ve failed to pay. A good credit history demonstrating you pay your debts and use your credit wisely will boost your credit score, while late payments and heavy credit utilization will lower it.
Why you should care about your credit score
A good credit score indicates that you are a trustworthy, low-risk borrower—someone who pays their bills and manages their finances well.
This can have a major impact when you apply for a mortgage, a business loan, or a credit account. A high credit score may help you qualify for a loan with better terms and a lower interest rate. A low score could mean that you don’t qualify for a loan at all or may only borrow with high interest.
Who uses your credit score?
Your credit score is a measure of your ability to pay, financial habits, and trustworthiness as a borrower. People or companies who have financial dealings with you may be interested in running a background credit check as a result, including:
- Banks and other financial institutions
- Credit card issuers
- Auto dealerships
- Insurance companies
- Potential employers
The 3 credit bureaus: Experian, Equifax, and TransUnion
Equifax, Experian, and TransUnion are the three major credit bureaus in the US. These credit bureaus collect your credit history, compile it in a report, and give you a credit score.
Your credit score may vary somewhat among the three agencies for a few reasons:
- Each credit bureau has a slightly different methodology for collecting information.
- The credit reporting agencies get information from businesses, lenders, and creditors at different times.
- Each major credit bureau has its own internal algorithm for determining your credit score.
Your credit report
Your credit report includes identifying information, i.e., your:
- Date of birth
- Social Security number
The report may also include your employment information, previous addresses, and other personal data.
However, the bulk of your credit report deals with your financial activity, such as balances, payment histories, loan applications, etc.
- Credit inquiries, regardless of whether you open an account
- Any open loans, including the loan date and amount, your monthly payment amount, your payment history, and the lender’s information
- Credit cards, or open revolving accounts, including your account balance, payment history, credit limit, the date of opening the account, and the bank information
- Closed credit accounts for up to seven years.
- Collection accounts (debt that you have failed to repay that has been moved to a collection agency)
- Public records such as tax liens, bankruptcy filings, and court verdicts
- Comments from you or creditors
The information presented in your credit report will determine your credit score.
Your credit score is a number, typically between 300 and 900, that indicates your reliability as a borrower. The vast majority of lenders will rely on your FICO Score, an algorithm developed by the data analytics company Fair Isaac.
Please note that credit scores may vary slightly depending on the end-use—for example, an auto score may be slightly different from a mortgage score.
What is a good credit score?
Most lenders consider a credit score above 700 good. A score at or above 700 will give you a better chance of qualifying for a mortgage or auto loan with advantageous rates and better credit card offers. A credit score of 800 and up is usually considered excellent and may result in even better loan terms.
On the other side of things, a score in the 600s may not qualify for certain mortgages, loans, or credit card offers. A score below 580 is considered poor, and some lenders may refuse to do business with you or will only offer unfavorable terms.
Different scoring models (FICO score and others)
Credit reporting bureaus will use one of the following methods to calculate your credit score:
The FICO score is hands-down the most widely used credit scoring method. It includes your payment history, debt, age and types of credit, and credit inquiries. Score range: 300-850.
Developed by the three major credit reporting agencies, VantageScore includes payment history, age and type of account, credit utilization, total balances, available credit, and credit habits. Score range: 300-850.
Equifax uses the Beacon Score to rank creditworthiness based on available credit data. Score range: 280-850.
Transunion uses the FICO-based Empirica Score to gauge creditworthiness. Only lenders have access to this score. Score range: 150-934.
How your FICO credit score is calculated
While the exact formula for calculating a FICO score is a trade secret, here are the components that make it up:
- Payment history (around 35%): Timely payments bring your score up, while missed or delayed payments negatively impact it.
- How much you owe (around 30%): Loans close to paying off will increase your score, while maxed-out credit, high balances, and new loans will lower it.
- Length of credit history (around 15%): This refers to making timely payments over a length of time.
- Types of credit (around 10%): Having varying accounts, such as home loans, installment loans, and credit cards, may boost your credit score.
- Recent credit activity (around 10%): Opening or applying to open several credit accounts in a short time hints at financial instability and may negatively impact your credit score.
Payment history and late payments
About 35% of your score is based upon payment history, making it the most impactful factor. If you want to acquire a good score, pay your bills on time—and do so consistently. Failing to do so will lower your credit score, and it could take you years to bring it up again.
Under Federal law, a lender may not report a late payment to the credit bureaus until it is at least 30 days overdue. A payment less than 30 days late shouldn’t damage your credit, but it might result in a late fee.
What if the payment is over 30 days past due?
Depending on the credit terms and your current score, being late on payments for 30 days or more can make your credit score plummet by up to 100 points. That damage could be especially severe if your credit was previously impeccable. If your credit score is already low, late payments will still hurt your score, but the difference won’t be as sharp.
Your credit score will suffer further if the late payment carries past the 60-day cutoff mark and then past the 90-day mark. Even if you are already late, make every effort to catch up on payments to repair the damage.
A late payment can remain on your credit report for up to seven years, but you can minimize the damage to your credit score with time and subsequent regular payments.
Length of credit history
Your credit history includes the total length of time you have used credit, a record of your payments and debts, and public credit records. It starts with your first credit card or loan and grows with time and new credit accounts. The length of your credit history will determine about 15% of your FICO score.
You can break down credit history into three main parts:
- How long your credit accounts have been open
- The length of time revolving and installment accounts have been open
- The time that has passed since you used these accounts last
AAoA: Average Age of Accounts
AAoA is a formula FICO uses for calculating the average length of credit history. The calculation is basic: combine the ages of your oldest and most recent credit accounts and divide by the total number of accounts.
When you open a new credit account, your average age of accounts drops. This will negatively impact your credit score. Opening a new credit account isn’t necessarily a bad financial strategy—but the effect on your credit score is something you should consider, especially if you plan to apply for a mortgage or major loan anytime soon.
How soon can you have a FICO score if you just opened a credit account?
If you’re a new credit user, you need to have an open credit account for at least six months before FICO can calculate your score.
It generally takes seven years to establish a positive credit history. Length of credit history can determine whether you qualify for certain types of mortgages, loans, or lines of credit. Every loan carries a level of risk for the lender, which is why lenders prefer applicants who have a long history of timely payments – something that translates into a good credit score.
However, some lenders are willing to work with people who have less credit history (young people or new immigrants, for example), provided they have hitherto displayed reliable payment habits.
Closed accounts will usually remain on your credit history record for ten years. However, if the account is fully paid off, it isn’t supposed to hurt your credit score. If your credit history includes an account with negative information older than seven years, you can try to remove it from your report using the credit report dispute process.
Types of credit
There are two main types of credit: installment credit and revolving credit.
- Installment credit refers to a fixed loan with a predetermined length and scheduled payments, such as a mortgage, an auto loan, or a student loan. The payments continue until the loan is paid off.
- Revolving credit is a line of credit that renews once the borrower pays off the debt, allowing repeated access to cash. Revolving credit does not involve borrowing a lump sum, and there is no fixed payment plan.
Generally, installment credit will have less of a negative impact on your credit score than revolving credit. Revolving credit is considered riskier and typically has a higher interest rate. For example, if you carry a high credit card balance, it will lower your score.
Credit utilization (available credit)
Credit utilization is the percentage of credit you have used out of your available credit card limit. For instance, if your credit card limit is $1,000 and your balance is $400, your credit utilization is 40%.
A low credit utilization demonstrates that you have no difficulty making payments and boosts your credit card score. A high credit utilization may damage your credit score and lead to a higher interest rate on your credit card.
The FICO model calculates credit utilization for every credit account you use and then looks at your overall credit utilization—your combined credit balances divided by the sum of your total credit limits. High credit utilization, either separate or overall, is bad for your credit score.
VantageScore also uses credit utilization as a significant factor in its formula.
Why is it bad to have high credit utilization?
If you’re nearly maxing out your available credit, it could indicate that you’re on the brink of falling behind on payments. This practice marks you as a higher-risk borrower and may make lenders think twice before they agree to work with you.
How can I lower my credit card utilization?
You can keep your credit card utilization down by following these simple practices:
- Spread out your credit card charges. If you have several credit cards, try to utilize 30% or less of each card’s limit.
- Time your payments. Every month, your card issuer sends a report to the credit bureaus. If your balance is high on the report date, it may negatively impact your credit score. To prevent this, make your card payments a few days before the billing cycle ends.
- Pay twice a month. If you pay off your credit cards mid-month, you can maintain an optimum utilization rate even if your total monthly expenses don’t change.
- Ask to increase your credit limit. If your credit limit goes up, but your spending habits remain the same, your utilization rate will drop, and your credit card score will climb up. However, if your annual income has gone down or you were late on a few payments, your credit card issuer might decide to reduce rather than increase your limit.
Collection accounts and charge offs
Debt collections and charge-offs have a severely negative effect on your score. Both indicate extremely late payments and may disqualify you for any new credit or loans.
- Debt collection happens when your original credit issuer assigns your credit account to a third-party collection agency, most often after several months of missed payments. Debt collectors may call, send payment notices, and even show up on your property.
- Charge-offs happen after 6 months, or 180 days, of failing to make your credit card payments. The card issuer will charge-off your account and report this information to credit bureaus. You will still need to pay off the debt, but you will no longer be able to use your credit card or make minimum monthly payments.
Both collection accounts and charge-offs will stay on your credit report for up to seven years. The only way to mitigate the negative impact is to pay off the debt, commit to responsible financial practices, and give it time.
Usually, people decide to file for bankruptcy after years of mounting charges and failing to pay off debt. While bankruptcy is something you want to avoid, when nothing else works, it can give you a fresh start, exempt you from paying certain debts, and even allow you to retain your home and car, depending on the court order.
Bankruptcy will have a devastating effect on your credit score. This effect is especially noticeable for people with good credit scores – if your score is 700, it will probably drop to around 500 when you file for bankruptcy. Scores in the 650-680 range will lose around 130-150 credit points after bankruptcy.
Bankruptcy will usually stay on your credit card report for a full decade, even if you discharge your debts. It can prevent you from obtaining unsecured credit, qualifying for a mortgage, or even getting life insurance.
There are two types of credit inquiries: hard inquiries and soft inquiries.
- Hard inquiries, or hard credit checks, typically occur when you apply for a credit card, loan, or mortgage. The potential lender or credit card issuer checks your credit report to determine whether to authorize the loan or credit card. You have to approve hard inquiries.
- Soft inquiries don’t require your permission. Usually, they occur when a company or person runs a background check on you. For example, an employer might decide to check your credit before hiring you.
A single hard inquiry could make you lose a few credit score points, but the effect is usually negligible. However, several hard inquiries concentrated in a short period could indicate that you’re applying for multiple loans or credit cards at once – which increases your potential risk as a borrower and may lower your credit score.
On the other hand, soft inquiries won’t influence your credit score, though they may appear on your credit report.
How to build credit
To build good credit, you need three main components: open accounts, regular, consistent payments, and time. At least seven years, to be exact. With time, both your average length of credit and your payment history will grow, boosting your credit score.
You will get a FICO score after six months of opening your first credit account, and your credit will improve with each month of timely payments and staying within your credit limit.
How can young consumers establish credit?
Building credit for the first time can be challenging, but you can apply for a secured credit card or a credit-builder loan. If your parents have credit, they can add you to one of their cards as an authorized user.
Some lenders are willing to work with young people who don’t have much or any credit history but otherwise promise to be low-risk borrowers. A reliable job, studying for an academic degree, and healthy financial habits can help you qualify for credit.
How to improve credit
If you already have a negative credit history that includes unpaid bills, exceeded credit limits, charge-offs, or even bankruptcy, you can still improve your credit with time, awareness, patience, and commitment to healthier financial habits.
- Check your credit and monitor it regularly. Among other things, it will help you avoid fraud and identity theft.
- Pay off debt and make timely payments from now on. This can be hard to do right away, but with determination and budgeting, you’ll get there eventually. Your creditors may extend some flexibility if you communicate openly and show commitment.
- Reduce your credit utilization. If you need to improve your credit score, aim to utilize no more than 30% of your monthly credit limit.
- Keep old accounts. If you have any credit accounts that show consistent, timely payments, keep them open. They can improve your credit history and score.
How to check your credit
By Federal law, you have the right to receive one free credit report a year from each of the three major credit bureaus. You can do this easily at AnnualCreditReport.com.
Many credit card companies also now offer free credit monitoring services within their online account management platforms, though this may only apply to one credit bureau. Make credit monitoring a regular practice. Keeping track of your credit will help you analyze your money habits and stay on top of your finances.