How does credit work?

It’s hard to imagine our financial lives without credit. A lucky minority can buy a vehicle or even a home outright, but most of us must rely on credit for some of life’s most important purchases.

Plus, it goes even deeper than that. Your credit is considered when you’re applying to rent an apartment or requesting utility services. Sometimes, it’s even a part of an employment background check. And in most states, car insurance companies check your credit when generating a quote for you.

So, what exactly is credit, and how does it work? Read on to find out and learn how to make your credit work to your benefit.

What is credit?

Credit is your ability to borrow money or purchase services or goods based on an agreement to pay back on specific terms. The terms usually include the amount of interest you pay and a payment timeline.

Not all credit accounts work the same, and borrowing terms vary by credit type. There are three main types of credit accounts: revolving credit, installment loans and open credit.

Revolving credit

Revolving credit allows you access to money from a financial institution up to a predetermined limit, Molly Ford-Coates, founder of Ford Financial Management, says.

At the end of each statement period – typically a month – you’re billed for the balance. You need to make at least the minimum payment to avoid fees and damage to your credit. However, if you don’t pay your bill in full, you’ll revolve the balance over the next month and pay interest on it.

“The plus side to this is the customer has the flexibility to choose how much money they borrow each month,” Ford-Coates says. “This may also be a downside if he or she is not a responsible borrower.”

When used right, this type of account can help you manage your budget and cover unexpected expenses when your emergency fund is running low. However, for longer financial commitments and large purchases, it’s usually a better idea to use installment loans – due to credit cards’ higher interest rates.

The most common examples of revolving credit are credit cards, personal lines of credit and home equity lines of credit.

Installment loans

“With most installment loans, money is borrowed and given to the customer upfront,” says Ford-Coates. “The customer then has to pay it back over a set period of time.”

Interest and any additional fees associated with the loan are also included in each bill.

The purpose of an installment loan is to provide a borrower with an opportunity to finance a purchase they might not be able to fund outright. While installment loan amounts tend to be high, lower interest rates and regular payment schedules make them easier to budget for.

Typical examples of installment loans include auto loans, mortgages, student loans and personal loans. Note that interest rates for personal loans tend to run higher compared to other types of installment credit. However, they can still be a good option for emergency expenses and debt consolidation.

Open credit

Open credit accounts don’t have credit limits but require you to pay the balance in full each month. For example, utility accounts have different balances each month that you need to pay in full to continue using the service.

Charge cards are also considered open credit accounts. They don’t have preset spending limits like credit cards – the amount you can charge on them can fluctuate depending on various factors such as your credit score, payment history and more. But whatever you spend, you’re expected to pay off the balance in full each month to avoid significant fees or even account closure.

What is a credit report?

Creditors, including merchants, lenders and service providers, define terms on which to offer you credit by assessing your creditworthiness. To put it simply, the better your credit history, the better your chances for credit approval on favorable terms.

Your credit history is reflected on your credit report, which is prepared by a credit bureau and reflects how you manage your credit. There are three major credit bureaus – Experian, Equifax and TransUnion – which is why you have three credit reports.

Your credit reports contain information such as:

• Credit accounts: This includes all your debt reported by lenders and details associated with it such as payment history, outstanding balances and the dates your accounts were opened or closed.
• Inquiries: Each time someone accesses your credit report, it triggers an inquiry. It can be a hard inquiry or a soft inquiry. A hard inquiry generally occurs when you apply for credit, while a soft inquiry would happen if someone checks your credit to verify information.
• Personal information: This includes your name, address and employers you mention on your credit applications.
• Public records: Your credit reports can also have information on bankruptcies.

What is a credit score?

The credit bureaus use the information on your accounts and inquiries in your credit report to calculate your credit scores. Simply put, a credit score is a three-digit number that reflects a borrower’s ability to repay debt.

“For anyone thinking of using credit, knowing your credit score is essential,” Andy Mardock, certified financial planner and president of ViviFi Planning, says. “A lower score may lead to a higher interest rate on your loan and potentially thousands of dollars in additional interest over your lifetime.”

You have multiple credit scores – not only because they are generated based on three different reports, but also due to the fact there are numerous scoring models.

FICO and VantageScore are two leaders in the credit scoring industry, and FICO is the most widely used model. You might notice your VantageScore and FICO scores are different from each other. This often happens because they treat credit data differently when generating scores.

“Not all credit scores are created equal,” Mardock says. “In fact, according to the Consumer Financial Protection Bureau, Fair Isaac Corporation – which is the developer of the commonly used FICO score – has offered more than 60 different credit scores since 2011.”

However, both the base FICO scores and the latest versions of VantageScore use the same 300 to 850 score range, detailed below:

In addition, FICO also offers industry-specific versions. For instance, auto lenders commonly use FICO Auto Score 8 and credit card issuers FICO Bankcard Score 8.

Why is credit important?

Credit gives you financial power by enabling you to purchase what you want at the time and pay for it later. Lenders look at your credit as a measure of how likely you are to pay back what you borrow.

So, it’s important maintain healthy credit so you can get more credit and so you can gain access to the best interest rates and lowest fees, whether you’re applying for a credit card, a mortgage or another type of loan.

Your credit is also important because these days, landlords, employers and even car and homeowner insurance companies might run a check on it before they offer you a place to live, a job or insurance policies.

Bottom line

Credit might be confusing at times, but maintaining good financial habits always helps. Take care of your credit health and you can reap all the benefits that come with good credit, be it a lower mortgage interest rate or that top-notch rewards card that you’ve always wanted.