How Does Credit Work? The Ultimate Guide

Too many borrowers can’t answer the most basic question: “How does credit work?”

Every time someone applies for a rental property, makes a major purchase, opens a cell phone plan, or turns on utilities like water and electricity for your home, we’re all reminded over and over again that our personal credit is important. We know that we need credit and that using it wisely is essential to having continued access in the future…

But because personal finance isn’t taught at most high schools or even universities, the majority of consumers learn about how credit works either from their parents or through painful trial and error—often only after facing the tough experience of being held back from their dreams and goals because of credit challenges.

So exactly how does credit work, and why should you be paying attention?

Read on, absorb these lessons, and share them with the people you care about. The sooner you understand the impact of your personal credit on your life, the better you can prepare for your business’s financial future.

How Does Credit Work? Personal Credit 101

How does credit work? If you’re brand new to the idea of credit, let’s start with the very basics.

Consumer credit comes into play whenever you borrow money as an individual. The person borrowing is responsible for making payment—and the information about amounts borrowed and timing of repayment is recorded on that person’s individual credit file.

Debts like car loans, mortgages, and credit cards are the most positive types of credit accounts, and creditors in these categories report both positive and negative payment histories to credit bureaus.

But those aren’t the only forms of credit that exist.

If you rent an apartment, have a cell phone, or use utilities for your home, those are all considered credit accounts as well—the company or creditor in question (think your property management or utilities company) offers you a service and expects you to remit payment after the fact.

However, these creditors differ in that they don’t typically report positive payment information. They’ll only be relevant to your credit history down the line if you’re significantly delinquent in payment.

Types of Credit

In addition to the different ways that creditors report a borrower’s payment history, there are also 2 main types of credit accounts, which work a little bit differently in terms of how they process payments and how they’re reported.

Let’s take a look.

Installment Credit

Imagine that you take out a 5 year car loan with 60 payments. When you first open the loan and make your first few payments, your utilization ratio (or your ratio of amount owed to amount paid) will be very high.

Closer to the end of the 5 years, on the other hand, your utilization rate will be much lower—because you’ll have made the majority of payments.

A traditional term business loan is a prime example of an installment credit account. It’s closed-ended with specific payment terms, a clearly outlined schedule, and an explicit end date. The utilization ratio on an installment credit contract always decreases incrementally over the life of the loan.

Other examples of installment credit account include car loans, student loans, mortgages, and personal loans.

Revolving Credit

Accounts labeled as revolving credit are probably the ones that you already associate most closely with credit or borrowing funds. The most notable of revolving credit accounts comes in the form of a credit card, which offers a set credit limit, minimum monthly payments, and charges interest on any balances carried from month to month.

The benefit of revolving credit?

It offers borrowers a lot of flexibility to spend money now but pay for the purchase when they have the cash available. Of course, that convenience tends to come with a hefty monthly fee in the form of high interest rates.

Types of Borrowers

Even so, not everyone who opens a revolving credit account actually revolves the balance on that account. Creditors typically classify borrowers as either transactors or revolvers, depending on how they go about using their revolving credit lines.

Transactors

In an ideal scenario, you’d approach every credit relationship with the goal of being a transactor.

You have a credit limit on your credit card or line of credit, you spend a certain portion of that limit, and you pay the balance in full each and every month.

The greatest benefit to being a transactor is that, when it comes to credit cards or lines of credit, you never have to worry about hefty interest payments. Because you aren’t carrying a balance month to month, interest charges will never kick in. But equally importantly, operating as a transactor in your credit relationships almost guarantees a positive credit history over time.

Revolvers

Let’s say you have a credit card with a $10,000 limit.

If you spend $5,000 towards that limit in one month but only pay back $1,000 of that amount, you’ll be revolving or carrying a balance of $4,000 on that card.

Borrowers who operate as revolvers typically have little, if any, margin in their personal finances. It’s easy to see how—if your spending continues to outpace your payments as in the example above—your levels of debt could skyrocket quickly.

In these scenarios, it only takes one unexpected expense or loss of income to turn a revolving borrower into a delinquent payer.

How Does Credit Work? Your Report Is Your Story

Now that you can answer “How does credit work?” and understand the ins and outs of different types of accounts and borrowers, you might be asking yourself, “Why does all of this even matter? Does anyone really care what type of borrower I am?”

Absolutely.

There’s a whole group of people—namely other creditors—who pay attention to how you borrow and repay funds. In particular, future lenders will look to your credit report in order to make decisions about whether to give you that new credit card, car loan, mortgage, or anything else that you’ll want to purchase with credit now or in the future.

Think of your credit report as the story of your financial life.

You apply for college and take out a student loan. You move into your first apartment and pay rent to a property manager. You buy your first car, then your first home, and have loans for each. And along the way you may have one or more credit cards, utility bills, or even medical expenses that are billed as credit.

Over time, your credit report records the ups and downs of your life story—and every money-related decision you make.

The Role of Credit Bureaus

But who exactly is telling the story of your financial life? Unfortunately for borrowers, your credit score isn’t a memoir. We don’t have full control over exactly how our narrative gets portrayed.

Instead, each borrower’s financial story is controlled by credit bureaus—the agencies that collect information about individual credit reports and synthesize it on behalf of lenders.

Think of credit bureaus as journalists collecting the facts and telling your tale. They’re well-meaning, and most of the time they get the story quite right… But now and then mistakes are made, or they might show an angle of your financial story that doesn’t provide full context.

The main three credit reporting agencies—Experian, Equifax, and TransUnion—each have their own proprietary method of collecting information about borrowers, meaning they can gather slightly different information at different times. And because different creditors report their payment information to different agencies, you can’t be sure that these journalists are all using the same (or the most accurate) sources.

We’ll talk more in a bit about taking control of your narrative to make sure that your credit history is accurately reported.

First, though, it’s comforting to know that there is one place where these different journalists reporting styles all come together—through the use of the FICO credit score.

How Does Credit Work? Figuring Out Your Score

If your credit report is the story of your financial life, your credit score is basically the SparkNotes version.

If you’re answering “How does credit work?” then you should understand how they’re related… And how they’re different.

Your credit score, that three digit number between 350-800, is meant to provide lenders with a snapshot view of your creditworthiness as a borrower—telling them whether your length of credit history, your payment record, and the types of accounts you hold indicate that you’re likely (or not) to consistently make payments on time in the future.

To calculate your credit score in a standardized way, credit bureaus use a complex formula known the FICO algorithm to evaluate various parts of your credit history.

The FICO Algorithm

Simply put, the goal of the FICO algorithm is to predict the likelihood that a borrower will default on debt payment within the next 18 months.

The lower the credit score, the more statistically likely the borrower is to default. By contrast, higher credit scores indicate that the borrower is less likely to default within the same time period.

With that goal in mind, let’s take a deeper look at the 5 components weighed by the FICO algorithm:

1. Payment History (35%)

As common sense would suggest, your past payment history is the single most influential factor determining your personal credit score.

Naturally, on-time payment history is good:

The more credit lines you have with an on-time payment history, the better your score will be. But the algorithm factors in more than simply whether or not you pay your bills. Things like severity (how far delinquent you are) and frequency (how many times you were late) help to determine exactly how your credit score will be impacted.

This means all late payment histories are bad, but the later they are, the worse it will reflect on your score. The first level of delinquency to impact your credit is at 30 days late. It’s not good, but 60 days is worse, and 90 days is even worse… And so on.

Timing is also a big factor in the impact of overdue payments.

Being currently delinquent is worse than being delinquent in the past.

So, for example, being 30 days delinquent as we speak will have a more negative impact on your current score than being 60 days late on a payment four years ago.

If you have a history of late payments but are working to turn things around, the good news is that the negative impact of your payment history won’t last forever. All negative payment histories age off your credit report 7 years after the first date of delinquency.

2. Amounts Owed (30%)

As the name suggests, this category reflects total amount of credit you currently owe—or have outstanding.

More importantly, though, amount owed also reflects the ratio of your current outstanding debt relative to your credit limit—also known as your utilization ratio.

To better understand this, let’s look back to the different types of credit that we reviewed above. Since your utilization ratio on installment credit accounts is fixed and always relative to the amount of time you’ve had the loan open, that ratio is less critical for the purposes of FICO’s algorithm.

The real importance of this ratio applies to revolving credit—again, those are things like credit cards and lines of credit in which you have a set borrowing limit, but can repeatedly borrow and repay funds within that limit.

You see, borrowers with high levels of revolving utilization are ultimately financing their lifestyles with very expensive debt, since carrying a balance month to month means paying very high interest rates. This high cost—along with the fact that these borrowers are typically living paycheck to paycheck—makes them precisely the targets of the FICO algorithm. Statistically speaking, these individuals are the single category most likely to default on a payment.

Sadly, what inevitably happens in many of these scenarios is that the borrower encounters some unexpected expense or an unexpected loss of income—a car repair, a medical expense, a temporary disability—and next thing they know, they’ve become a delinquent borrower.

Don’t let this be you! To stay within safe borrowing limits and keep your credit score on the up and up, aim to stay within FICO’s recommendation of a 30% utilization rate or lower. This means if your credit card limit is $10,000, you should never charge more than $3,000 at a time before paying down the balance.

3. Length of Credit History (15%)

When you take out your first credit card, car loan, or student loan, FICO and the credit bureaus are waiting to see what kind of borrower you will be.

Will you make your payments on time? Will you budget and plan ahead for upcoming payments?

In the beginning, FICO doesn’t have those answers, so their algorithm doesn’t have much to go on.

From a statistical perspective, the more data points that FICO has (like months and years of payments made or not made on time), the more confident the algorithm can be about its overall prediction of your future behavior. So if you only have 6 months of credit history, there’s not a lot for the algorithm to work with in terms of data.

This category can severely impact new borrowers, who will often have a lower credit score for a year or two after opening their first account. The good news is that in this category at least, your credit score will keep going up the longer you are listed as a borrower.

4. New Credit (10%)

Each time you submit an application for a new credit account—whether that be to open a new credit card, rent an apartment, buy a car, or take out a personal loan—the lender will most likely pull your credit report with at least one, if not multiple credit bureaus.

New accounts are always preceded by credit inquiries, and they tell FICO’s algorithm that you’ll probably be borrowing more money soon. That’s going to create a new account for which the algorithm can’t yet track a payment history, so both the inquiry and the opening of the account will negatively (though temporarily) impact your credit score.

If you check your credit score very regularly, you’d likely see it go down just slightly after an inquiry, and even more so right after you open that new account. But eventually, after one month, three months, six months, and a year of positive payment history on that account, the negative impact on your score from that new account will continue to dwindle.

5. Credit Mix (10%)

Did you know that your statistical likelihood of making on-time payments can vary widely depending on the type of account?

This can seem surprising as a blanket statement, but it makes sense when you think about it: 

In general, borrowers are much more likely to be late on a credit card payment than they are on a mortgage or car payment. After all, if you miss a few car payments, the lender can take your car away! And the same can be said for your home. But if you’re late or fail to pay your credit card bill, there’s fewer direct or immediate consequences to be had, so these unsecured accounts are more likely to face delinquent payers.

Remember, the FICO algorithm’s goal is to predict your future borrowing and repayment behavior not just for a certain type of credit accounts, but for all possible types of credit. To make this prediction as accurately as possible, the algorithm needs to see how you’ve handled borrowing under any number of circumstances.

For this reason, the credit mix portion of the algorithm measures whether you have a varied mix of credit account types represented. The more variety is shown, the better you’ll do in this category.

Now that we’ve reviewed the 5 factors that the FICO algorithm, the credit bureaus, and ultimately potential lenders are paying attention to in your credit story, what can you do to make sure the best possible version of your story is told?

Let’s take a look at a few ways you can take back control of your own financial narrative.

Take Ownership of Your Credit Story

What would you do if you knew that false information were being spread about you at work, in your neighborhood, or in your larger community? Would you ignore it? Would you bury your head in the sand and refuse to notice that it was even happening?

Or would you stand up for yourself, doing what it takes to make sure the truth is revealed and your image is restored?

If you wouldn’t stand for your good reputation being tarnished in the real world, why would you allow false information to muck up your financial reputation? And yet, few consumers realize that they may be one of the 1 in 20 individuals with false information on their credit reports—and even fewer take steps to do anything about it.

Remember, your credit report is your financial story, as told by the major credit bureaus. But because each agency has its own proprietary method of collecting information about borrowers, they can gather slightly different information at different times.

To complicate matters even further, the Federal Trade Commission suggests that because of issues like name changes or similarities, changes of address, and clerical errors, credit reporting errors are far more likely than most consumers expect. As the consumer, if one or more of the credit bureaus have gotten your story wrong, the burden of responsibility is on you to notice and to get a correction in place.

This means first and foremost, you should be pulling and reviewing your credit report regularly—at least once a year, if not more frequently—from all three major reporting bureaus: Experian, Equifax, and TransUnion.

If you can’t remember the last time you pulled your credit report, do that first.

Right now…

We’ll wait!

Now, don’t you feel better knowing where you stand?

Of course, if you found errors on any one of your credit reports, it’s important that you take steps to fix it by contacting the reporting agency in writing. A word of warning: the process of correcting your credit report can be long and tedious!

But it’s very much worth taking these extra steps to make sure your story is told well.

How Does Credit Work For You?

Beyond knowing what your credit report says and resolving any mistakes, what can you do to take the fear out of the credit process and make your credit work for you?

Let’s review 6 big steps you can take at every stage of the game.

1. Start Early

We realize that for many of our readers, it might be a bit too late to make use of this first recommendation—but it’s still worth passing on to your children or other young people you know!

We know that 15% of the consumer credit score is based on length of credit history, so there’s value in starting early to develop a positive payment history.

Anyone over the age of 18 can apply for a credit card, although their options may be more limited at first. It’s worthwhile for a young person to get a starting credit card as soon as they are of age, even if it is co-signed by their parents.

Of course, it’s important for young adults to be well-educated in financial literacy before they start using credit. Encourage the young adults in your life not only to use credit, but to follow sound practices for usage and re-payment.

2. Aim to Be a Transactor

When it comes to revolving accounts like credit cards and lines of credit—for as long as possible, you should always aim to be a transactor.

As you learned, transactors are borrowers who use things like credit cards for the convenience or perks, but who pay their balance in full every month. While this goal may not always be possible as your personal needs grow, starting this habit as your norm from the beginning of your credit life will help you to avoid getting in over your head in the future.

3. Don’t Over-Do It

There’s no denying that when used responsibly, credit is a valuable tool. The problem that too frequently arises, though, is that consumers fall down the slippery slope of using credit as a free ride to live beyond their means.

While it’s smart to maintain a mix of credit accounts early in your life in order to establish a strong credit history, don’t confuse the ability to access credit with the ability to afford a certain lifestyle. If you’re living paycheck to paycheck, only making minimum payments, and continually opening more and more lines of revolving credit, it’s too easy for one seemingly harmless decision at a time to turn into a personal credit crisis.

Avoid overextending yourself financially by building a budget and sticking to it—starting with exactly how much of your credit you will actually use. As a rule of thumb, stick with the often-cited recommendation of 30% utilization: that means never charging more than 30% of your total credit limit without paying down the balance.

Create some margin in your finances by maintaining a cushion of cash—ideally 3 to 6 months of living expenses if you can. If you’re currently in debt but turning things around, start by paying off the most expensive debt (i.e. credit cards or lines of credit with the highest interest rates) to pull yourself out of that revolving credit hole.

4. Look For Variety

If you’re going above and beyond in your pursuit for a top notch credit score, you can take proactive steps by making sure that you have a variety of credit accounts. Remember, your credit mix accounts for 10% of your total credit score, so this is an area where—if you act wisely—you might be able to score a few bonus points.

In addition to a credit card or two that you pay off regularly, make sure that you have a few installment credit accounts as well. For example, there’s nothing wrong with taking out a loan for a car if you’re confident that you can make the payments regularly.

The same is true for rental and leasing properties, provided that the company you lease from is actually reporting your positive payment history to the credit bureaus. Many property managers, utility companies, and other companies in this credit category only report negative information to the bureaus, so it’s worth checking with any new creditor to learn about their policies.

5. Always, Always Pay On Time

It should be obvious by now that there’s nothing more crucial to maintaining a solid credit score than paying your bills on time, every time.

At the end of the day, this is the entirety of what FICO, the credit bureaus, and lenders are monitoring—whether or not you’ve made payments on time in the past and whether you’re likely to continue doing so in the future.

If you’ve struggled with making on-time payments in the past, it’s time to re-evaluate your cash flow and lifestyle to determine if you’re spending beyond your means. Whatever must be done for you to get a handle on your monthly payments is ultimately an investment in your long-term financial future.

6. Get Organized

For some people, late payments or even occasional delinquent accounts are a product, not of overspending, but of failing to organize and keep track of their outstanding accounts.

But there’s truly nothing more unfortunate (or easier to solve) than letting unpaid bills negatively impact your credit score when the money to pay them is readily available in the bank…

You just have to get organized!

If you’re prone to letting stacks of mail sit unopened on the counter-top, forgetting about newly opened credit accounts, or failing to change your address with the post office when you move, you might be delinquent on payments without even realizing it.

To solve this, create a simple and repeatable system for paying your bills.

When will you open your mail? When will you sit down to write checks or make payments online? Would it help you to create a simple table tracking when payments are due, or sign up for auto-pay functions where available? Have you added due dates for all your bills to your family calendar?

These steps might sound overly simple, but you’d be surprised how many individuals find their credit scores taking a hit because of small oversights.

Don’t Wait For a Quick Fix

All it takes is a quick online search to find hundreds of articles, tutorials, and even courses claiming they’ll teach you to hack your credit score or promising a quick fix for repairing personal credit.

These experts might have good intentions—but the unfortunate reality is that there’s no such thing as a quick fix for personal credit. You can’t snap your fingers and unwrite your credit story.

And besides, if you think about it, a quick and temporary fix to your credit history can only hurt you in the end. Lenders created the credit reporting and scoring system not only to protect their own interests, but in a way to save borrowers from themselves.

By finding a way to reverse engineer the system only to gain even more credit, borrowers almost guarantee digging themselves into an even deeper credit hole.

How Does Credit Work? Now You Know!

Next time someone asks you “How does credit work?”, we hope that this guide will serve as a valuable resource to help you explain the impact of your credit in a way that makes sense.

But even more importantly, we hope that it will help you to make wise choices about your credit moving forward and be more mindful about the way your financial story is told.

The post How Does Credit Work? The Ultimate Guide appeared first on Fundera Ledger.

from Fundera Ledger https://www.fundera.com/blog/2016/08/03/how-does-credit-work/