Table of Contents
What is credit?
Credit is your ability to borrow money or use goods or services on the understanding that you’ll pay your lender back in the future. Credit cards and loans (like student loans, car loans, and mortgages) are some of the most common forms of credit.
The term “credit” also has a second meaning. People often use it as shorthand for “credit history,” which is the record of your financial decisions that appears on your credit report. The ways in which your credit history affects your life are explained in more detail further down in this article.
How to get credit
To get a new credit account (sometimes referred to as a line of credit), you have to submit an application to a creditor, such as a bank. When reviewing your credit application, your creditor will evaluate your finances and credit history to determine how much to lend you and under what terms. Lenders are generally much more likely to offer you a loan if you have a good credit score.
What are the main types of credit?
There are three main types of credit that you can have:
Installment accounts
Installment loans (or closed-end credit accounts) are loans that you borrow in a lump sum and repay over a set schedule.
You’ll usually repay a portion of the borrowed amount (known as the “principal”) every month, plus an extra fee. This is known as interest, and is determined by the account’s interest rate. Once you’ve cleared your debt, the account will close.
Mortgages, auto loans, and student loans are all examples of installment loans.
Revolving accounts
With revolving credit (or open-end credit), you can repeatedly borrow as much (or as little) money as you want up to your account limit.
Generally, you only pay interest on the balance that you haven’t repaid each month. Your unpaid balance will carry over (or “revolve”) into the next month.
A revolving account will usually stay open until you choose to close it, providing you repay the minimum balance each month and don’t let it become inactive.
The three most common types of revolving accounts are credit cards, home equity lines of credit (HELOCs), and personal lines of credit.
Open accounts
With open accounts, you repeatedly borrow funds, but you must repay the borrowed amount in full every billing period. The amount you borrow can vary from one billing period to the next. Because you’ll always repay the amount in full, you don’t usually pay interest on open credit accounts.
Common examples of open accounts include home utilities, membership services (like internet and mobile phone services), and charge cards (credit cards you must repay in full every month).
It’s unusual for utility contractors and service providers to report your payments to the credit bureaus, unless you have a late payment. For this reason, you may not see open accounts (except for charge cards) on your credit report.
How credit reports work
Your credit report is a file containing information about your credit history and your current activity. You have a credit report with each of the three major nationwide credit bureaus (TransUnion, Equifax, and Experian). These bureaus gather information about your credit history from your lenders and public records.
Generally, lenders report to the bureaus about your credit activity every 30–45 days. 2 They aren’t required to report to all three credit bureaus (or any at all, since credit reporting is voluntary), so it’s normal for your reports to be slightly different from one another. 3
Under the Fair Credit Reporting Act, you’re entitled to a free copy of your credit report from each of the main credit bureaus once per year, which you can get at AnnualCreditReport.com. 4 You should regularly check for and dispute errors on your credit report.
What’s in your credit report
Your credit reports contain the following information: 5
- Credit accounts: The number and types of credit accounts you have, the date they were opened, how much you borrowed, how much you currently owe, and whether you’ve paid your bills on time.
- Credit inquiries: Any hard inquiries you’ve triggered by applying for credit in the past two years. 6 Soft inquiries (which aren’t related to a formal application) also appear on your report, but you’re the only one who can see them.
- Bankruptcies: As of 2018, public records like tax liens and court judgments can’t appear on your credit report, but bankruptcies can. 7
- Your personal information: Basic information like your name, address, Social Security number (SSN), date of birth, and employment information.
Lenders use the information above to determine how likely you are to default on a loan (fail to repay it) and decide whether to extend credit to you.
How credit scores work
Your credit score is a three-digit number that represents your risk as a borrower, and it’s based on the information in your credit report.
The two main credit scoring companies are FICO and VantageScore. They release new scoring models every few years, which is why you have many different credit scores.
In the current versions of both of these models, your score ranges anywhere from the lowest credit score of 300 to the highest credit score of 850, with a higher score being better.
How to check your credit score
Because credit scores and credit reports are different products, your credit score won’t show up on your free credit reports. Instead, you can check your credit score for free online or through a credit-monitoring service.
You might also be able to find out what your credit score is by checking your credit card or loan statement because many lenders partner with the scoring models. Alternatively, a federally-approved credit counselor can often tell you your credit score at no charge.
How is your credit score determined?
The two major scoring models calculate your credit score based on a few factors:
- Payment history: Your record of on-time or missed payments.
- Amounts owed and credit utilization rate: Your total debts and the percentage of your available credit that you’re using.
- Length of credit history: The age of your credit accounts.
- Credit mix: The variety of different types of credit accounts you have.
- New credit: How many accounts you’ve opened recently and the number of hard inquiries on your credit report.
Although the major credit scoring models are pretty similar, FICO and VantageScore have several differences. For example, they have different weightings for the above factors, as shown in the tables below.
| Payment History | Amounts Owed | Length of Credit History | Credit Mix | New Credit | |
|---|---|---|---|---|---|
| FICO | 35% | 30% | 15% | 10% | 10% |
| Payment History | Credit Utilization | Depth of Credit | Recent Credit | Balances | Available Credit | |
|---|---|---|---|---|---|---|
| VantageScore 3.0 | 40% | 20% | 21% | 5% | 11% | 3% |
| VantageScore 4.0 | 41% | 20% | 20% | 11% | 6% | 2% |
To gain a solid understanding of how credit scores work, you’ll need to know how your actions influence each of these categories.
Payment history
Your payment history is the most important factor contributing to your credit score. On-time payments will help you build your credit, but missed payments can seriously hurt it.
For instance, a 30-day late payment can cause your FICO score to drop by 80 points or more in some circumstances. The longer your payment is overdue, the greater the damage. 8
The following negative marks also hurt your credit because they show that you’ve defaulted on your payments:
- Charge-offs
- Collections
- Repossessions
- Foreclosures
- Bankruptcies
For example, an unpaid parking ticket could lower your credit score if it’s reported by a collections agency.
Amounts owed/credit utilization
How much debt you owe across all of your accounts also has a major effect on your credit. As you pay down your loans, your credit score will usually increase because you’re demonstrating that you can honor your credit obligations. 9
The credit scoring models also measure how much of your available credit you’re using on your revolving accounts, both for each individual account and across all of your accounts. 10 This is known as your credit utilization rate, or your debt-to-credit ratio.
Generally, the lower your card balances, the better. Many experts recommend keeping your utilization below 30%, although VantageScore disputes this advice and says that under 10% is ideal. 11 FICO has revealed that borrowers with the highest credit scores use less than 6% of their available credit on average. 9
Length of credit history
The main metric that affects the length of your credit history is the average age of your accounts. The older your accounts are, the better.
Opening a new account can cause a drop in your credit score because you’re causing a decrease in the average of your accounts. However, it generally won’t take long for your score to recover.
Fortunately, closing an account doesn’t affect the length of your credit history in FICO’s model because they still factor closed accounts into your credit age until they fall off your credit report. This typically takes 7 years (if the account was delinquent) or 10 years (if it was in good standing). 12 13
It’s unclear whether VantageScore considers closed accounts. Some of their experts say they do, whereas others say they don’t. 14 11 As long as your account fees aren’t too high, it’s usually better to keep your accounts open; that way, you won’t risk hurting your VantageScore.
Credit mix
The types of credit accounts you own have a small influence on your credit score. Having a variety of accounts can help you to get a good credit score, and in turn a better loan.
A good credit mix consists of at least one revolving account and one installment loan. Open accounts don’t generally contribute to your credit mix. 15
New credit
The New Credit category doesn’t account for a large percentage of your credit score, but it’s still one of the five key scoring factors you should be aware of.
Lenders usually check your credit when you apply for a loan or credit card. This triggers a hard inquiry, which causes a temporary drop in your credit score. The number of points you’ll lose from a hard inquiry won’t be substantial, usually no more than five points in FICO’s model or 10 points in VantageScore’s, although too many hard inquiries can cause more serious damage to your credit. 16 17
Thankfully, both FICO and VantageScore have a rate-shopping period during which they count multiple inquiries of the same type as one. This allows you to compare loan terms with various lenders without multiple hits to your credit score. This shopping period is 14 days in VantageScore’s model and 45 days in FICO’s model, although FICO only applies this rule to inquiries for mortgages, student loans, and auto loans. 18 17
If you only apply for credit when you need it, you usually don’t need to worry about the effect of new credit accounts on your credit score.
What is credit used for?
Your credit score is primarily of interest to lenders, who use it to assess your risk as a borrower when deciding whether to issue you a loan or credit card.
In general, lenders base the following decisions on your credit score and history:
- How much money to lend to you (i.e., your credit card limit or loan amount)
- The length of your repayment period
- What interest rate to offer you
- Whether to offer you unsecured credit or only secured credit that’s backed by collateral
- Whether to offer you exclusive deals, such as 0%-APR or rewards credit cards
It’s also worth noting that credit scores aren’t international, so your US credit score really only matters to US lenders and won’t affect your life if you move abroad.
Other uses of credit
Lenders aren’t the only ones who care about your credit score and history. In many cases, you’ll need to pass a credit check to do any of the following things:
- Rent a property: Landlords often check your credit to assess how likely you are to pay your rent on time.
- Get a job: Some employers won’t hire you if you don’t pass a credit check, especially if you’re applying for a job at a financial institution. 19
- Qualify for cheaper insurance: Insurers sometimes use your credit as an indicator of how likely you are to file an insurance claim, and they may charge you a higher premium if you have a bad credit score. 20
- Obtain utilities and services: Utility and service providers check your credit to see if there’s a risk you might not pay your bills. If you have a good credit score, they may waive your security deposit.
How to work on your credit
It might take a long time to improve your credit, but it’s possible with a bit of determination.
All you need to do is follow these tips:
- Always pay your bills on time: Always making on-time payments is the most effective way to strengthen your payment history and increase your credit score. It’s also important to catch up on overdue accounts to prevent new negative marks from appearing on your report.
- Keep your revolving balances low: There are several ways to get your credit utilization under 10%. You can reduce your spending, spread your balances across your cards, or ask your card issuer for a higher credit limit.
- Be careful when applying for new credit: Opening a new account can potentially boost your credit score by lowering your credit utilization rate and improving your credit mix, but it can also hurt your score in the short term and make it harder to manage your bills. Carefully weigh the pros and cons beforehand to ensure it’s the right move.
- Monitor your credit reports: One in five people have errors on their credit reports, and these errors can have a serious impact on your credit score. 21 Regularly check your reports from all of the main credit bureaus to ensure you’re getting the credit you deserve and to identify areas for improvement.
You can also consider taking out a credit-builder loan or asking someone close to you if they’ll add you as an authorized user onto their credit card account, both of which can boost your score.
