What Is Credit and How Does It Work?

Generally speaking, credit allows you to borrow money now and pay the lender back later — usually with interest. But there’s a lot more to it than that. Having a solid understanding of what credit is and how it works is important because it affects many aspects of your life.

What are the different types of credit?

There are essentially three different types of credit: revolving, installment and service.

Revolving credit

With revolving credit, you are given no money up front. Instead, you are given an account with a maximum credit limit, and you can use the account to make as many purchases as you want within that limit. You can then choose to pay those purchases off every month or carry the balance (in other words, revolve the debt). If you choose to carry a balance, you will usually be expected to make at least a minimum payment every month. Credit cards are a common example of revolving credit.

Installment credit

This is when you get a specific amount of money from a creditor and repay the funds — with interest — in regular installments over a specified time period. Mortgages and car loans are both examples of installment credit.

Service (or open) credit

Anytime you are provided a service or utility for which you are billed later, it falls under the heading of service credit. Most service accounts do not appear on your credit report. Charge cards, not to be confused with credit cards, also fall under the service (or open) credit category because they must be paid off each month.

What is a credit score?

Your credit score is a three-digit number that indicates your creditworthiness. Most credit scores fall between 300 and 850. One of the most popular credit score models used by lenders is FICO.

Not sure how your FICO Score ranks? Here’s a look.

Your credit score may vary depending on which of the three national credit reporting agencies you use to get your report. This is completely normal because all creditors do not report to every bureau.

A credit score is influenced by five different factors, including:
  Payment history: 35%
  Amounts owed: 30%
  Length of credit history: 15%
  Credit mix: 10%
  New credit: 10%

These percentages are standard for the general population but can vary slightly from one person to the next.

Why do credit scores matter?

Credit scores show how trustworthy you are with your debts. Financial institutions want to lend funds to borrowers who can manage their loans properly and pay their bills on time.

Just as lenders feel confident loaning money to borrowers with a high credit score, they may be hesitant to lend to you if you have a low score, indicating you haven’t paid your debts on time — or at all. If you’ve never borrowed money, you may have no credit score at all.

When making a major purchase like a house or car, 90% of top lenders will check your FICO Score as part of the loan approval process. Potential lenders use your score not just to decide whether to approve you, but to determine your interest rates.

What’s in my credit report?

If you want to see what sort of information is included on a credit report, you can check out a sample credit report from Experian. Let’s take a closer look at the different elements.

Personal information

This includes your name, Social Security number and any addresses associated with your accounts. This personal data is not factored into any scoring models, but it’s important to make sure it is correct to protect you if you ever need to prove your identity.

Personal statements

You have the option to write personal statements that will appear on your credit report. They stay in place for two years and are visible to anyone with access to the document. For example, if you were briefly unable to pay your bills because of a natural disaster, you might include a statement explaining that.

Potentially negative items

Issues highlighted in this section include late payments, charge-offs (also known as accounts sent to collection) and bankruptcies. However, not all this information is necessarily negative. Some items could be included here so potential creditors have the option to put them under closer scrutiny.

Accounts in good standing

Just as the name suggests, this section contains a list of accounts with a positive status. Since some creditors don’t report to all three bureaus, some of your favorable accounts might not be noted. Accounts reported by creditors will contain up to two years of your monthly balances.

Credit inquiries

Here you’ll find the names of businesses that have requested your credit information. This list can date back a maximum of two years.

6 tips for building good credit

Building good credit takes patience, but it’s not impossible. Here are ways to improve your score.

Pay bills on time

Because payment history is the most heavily weighted factor of your credit score, the best thing you can do for your credit score is to pay your bills on time. FICO uses three general factors to score the impact of late payments: how recently you made the late payments, how severe they were and how often this happens.

Keep your oldest credit card active and open

If you’re no longer using your first credit card, you’re probably tempted to close it. However, this could negatively impact your length of credit history. Rather than close old cards, simply put them in a drawer or cut them up. This way, you lengthen your credit history without adding to your debt.

Check your credit report and credit score regularly

Keeping a close watch on your credit report can allow you to spot inaccurate information, including fraud, in a timely manner. You’re allowed to check your scores as often as you like without penalty. You’re also able to obtain one free credit report every 12 months from each of the three national credit reporting agencies by visiting AnnualCreditReport.com.

Diversify your credit mix

Since credit mix composes 10% of your FICO Score, having a variety of credit cards, retail accounts, installment loans and finance company accounts can boost your score. However, FICO noted it isn’t necessary to have one of each and advised against opening an account you don’t need.

Don’t overextend yourself

Your credit utilization ratio — the amount of your debt relative to your overall credit limit — is a significant part of your score, so you want to keep it low. most experts suggest keeping this number under 30%. Though keeping your balances low is the best way to maintain a good utilization ratio, you can also call your credit card provider to ask for a raise to your credit limit.

Start early

If you don’t have credit yet, start early and small. Open an account you know you can pay off each month, like a credit card with no annual fee, for a low-stakes way to build credit.