A Simple Guide to Credit: What Credit Even Is and How You Can Improve It

In my last post we talked about paying off debt, so I figured a natural follow-up would be to talk about credit and how to improve your score.

I didn’t understand credit for a while.

I didn’t have a credit card until my last year of college and was pretty adamant about not getting one. My thoughts were that credit cards were bad and that I would never need one if I only planned to spend money that I already had.

Cassie gently explained to me that I probably needed to get one in order to start building credit, since I hadn’t needed to take out any student loans and didn’t have a car loan. At that point in time, I was pretty much a ghost to the world of credit — in fact, the first time I tried to sign up for Credit Karma, they couldn’t find me.

My principled stance against credit cards was great in theory, but not so great in the capitalist reality we currently live in. And my lack of credit at the time made it difficult to get approved for my first card, which was such a catch 22! (Thanks to Discover for approving me way back when!)

Since my first credit card, I’ve come to be a big fan of the responsible use of credit cards and currently have over $1,500 in cashback and travel rewards saved up for when I can finally travel again.

Understanding how credit and credit cards work helps you take advantage of them, rather than them taking advantage of you.

We won’t be going into all of the details of travel hacking and sign-up bonuses in this article, but we will cover the basics of understanding credit and how to improve your score (so that you’ll be able to qualify for those cards with great sign-up bonuses, when you apply!).

So, let’s dive in!

What Is Credit?

Credit is essentially money that is loaned to you with the expectation and promise that you will pay it back at a later date, usually with interest. Generally, this looks like lines of credit provided to you through credit cards, a mortgage, and other various types of loans.

There are three types of credit: Revolving, Installment, and Open.

The most common type of revolving credit is credit cards. You are only required to pay the minimum balance and the remaining balance rolls over to the next month (revolving).

Installment credit is credit that has a set payoff timeline with a fixed amount due each month, like a car loan or mortgage.

Open credit examples typically don’t have interest and are things like your utilities. You’ve received your water or electricity for the month on credit with the expectation that you will pay for it when your bill comes due at the end of the month.

However, when someone talks about your credit they are usually referring to your credit score.

How Credit Scores Work

Your credit score is a number between 300 and 850 that represents your creditworthiness based on your credit history. There are different scoring systems that have their own unique ranges bands, but FICO is the most common, and their range is as follows:

Excellent: 800 to 850

Very Good: 740 to 799

Good: 670 to 739

Fair: 580 to 669

Poor: 300 to 579

Your score is determined by a variety of things that we’ll get to shortly!

Why Credit Scores Are Important and How They’re Used

Your credit score will affect not only your ability to actually borrow money in the first place, but also the interest rate you will be required to pay on the borrowed funds.

The better your credit score, the lower the interest rate. The lower your credit score, the higher the interest rates you’ll be charged to borrow money.

By building up good credit and keeping your score high, you’ll end up saving a lot of money in the long run, thanks to those lower interest rates.  

For example, according to Nerd Wallet, someone with a FICO score of 620 would pay $65,000 more on a $200,000 mortgage than if they had a credit score of 760.  That’s a lot of dollars!

But aside from interest rates and credit applications, your credit score is used for lots of other important things. If you’re looking to rent a house or an apartment, your landlord will look at your credit score as one factor in whether or not they’ll rent to you. Your auto and home insurance premiums are partially determined by your credit score, too.

Employers will also sometimes check the credit reports (but not scores) of applicants.

For all of these reasons, it’s a good idea to pay attention to your credit and work to improve it. Next up, we’ll talk about how to do that!

What Affects Your Credit Score (and How to Improve It)

You can keep track of your current credit score by using the free app Credit Karma. Most banks and credit card companies now come with some form of a free credit score tracking service, too, which can help you catch fraud faster. If you don’t know your credit score, find it out! This will let you know where you’re starting.

You also have the right to request a free credit report from the three major credit bureaus (TransUnion, Equifax, and Experian) once a year by visiting annualcreditreport.com. Your credit report provides a much more detailed picture of your credit history and the things that are affecting your score. It’s good to look through this once a year to keep your eye out for any mistakes that may have shown up on your report and be unfairly affecting your score.

How Your Credit Score Breaks Down

Payment History: 35% of your score

Your payment history makes up the largest chunk of your credit score and therefore has the biggest impact. That’s why it’s incredibly important to avoid late payments (or missing payments entirely). They can negatively affect your score for up to seven years!

To simplify things, set up auto pay for at least the minimum payment on your credit cards and loans. That will ensure that you avoid the dings to your score and the associated fees.

If you accidentally make a payment a day or two late (and it’s not a common occurrence for you), you can usually call your credit card company and ask them to forgive your late payment this one time and not to not report it.

Credit Utilization: 30% of your score

Your credit utilization refers to the percent of revolving credit you have access to that you are actually using. So for example if you have three credit cards that when added together have a $10,000 credit limit, and your current balances add up to $2,500, then your credit utilization would be 25%. That’s because you are currently using 25% of the credit available to you.

It’s general guidance to keep this amount below 30% to not negatively affect your credit score, and if you can keep it under 10% then all the better!

Credit History Length: 15% of your score

The length of your credit history can either help or hinder your credit score. There’s nothing you can really do here — just be patient! But, this is one of the reasons why starting to responsibly use credit sooner rather than later can be helpful. Getting a 0% interest, low-limit credit card just as you start college (and paying it off consistently and completely) can help you later on. If you’re not a student, you may still be able to access credit cards designed for credit newcomers.

Credit Mix: 10%

Credit agencies like to see a mix of types of credit such as credit cards, an auto loan, mortgage, etc.

I wouldn’t worry about this too much because it doesn’t have that big of an impact on your score, relatively. I recommend having a few key credit cards that you pay off each month, but otherwise, only borrow money for things you need to borrow for.

It doesn’t make sense to take out a car loan and pay interest if you can pay cash. Same for student loans.

New Credit Lines (Hard Inquiries): 10%

If you’ve recently opened a bunch of credit cards or taken out multiple loans, this is a red flag to lenders and will impact your credit score.

When you open any new line of credit you may see your score dip immediately afterward because of the hard inquiry they made. A hard inquiry is when a lender pulls your credit report to determine whether or not to approve you for credit.

Hard inquiries stay on your credit report for up to 2 years, but as long as you don’t more than three or four inquiries in that two-year period, it shouldn’t really affect you too much.  

People sometimes get really stressed about the hard inquiries component of credit scores, but honestly, I wouldn’t worry a ton about it. The dip is temporary, and the newly available credit will reduce your credit utilization which will have a bigger net-positive impact on your score.

Important Note: The only time I would say to be wary of opening a new line of credit is if you plan on making a home purchase in the near future. This temporary dip could affect the interest rates you’re offered, and on a $200,000 mortgage that small difference in interest rate can equal a lot of money!

Your payment history and credit utilization are the things that have the biggest effect on your score, so they are definitely the ones to keep an eye on. Make those payments on time and try to keep your debts low and pay them off as soon as possible.

Credit Karma will walk you through each of these factors and explain how they are affecting your particular score, so that’s a great place to start if you’re generally new to understanding the world of credit! And remember, you may not see instant change as you work to improve your credit, but by diligently sticking with it and working to improve your score you will see slow and steady progress and get to where you want to be!

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