Understanding How Credit Works

Man teaching another man how credit works.

Usually, when I place credit in the investing category, most people look at me like I’m crazy.  Credit is for spending, they think.  After all, credit helps you buy things, and buying = spending.  But buying isn’t always spending.  Buying is often investing.  If you buy stocks, do you consider yourself to be spending money?  No, you consider yourself to be investing, which could be considered spending, saving, and earning all at the same time.

It is true, though, that most people look at credit as a way to buy the things they want in life. Specifically, depreciating or consumable things like vacations, cars, clothes, shoes, food, and entertainment.

As someone who is interested in living their best life and managing their money responsibly—as I can tell you are because you are here—you should primarily think of credit as a tool to purchase assets.

This means you have to break the mental connection between credit and spending.

Credit Has Its Place

That said, there is a responsible way to use credit, and that includes a responsible way to use credit cards.  It can even be important to use credit before you’re at a point in your life where you’re ready to use it to launch investments. After all, you need to build some credit in order to use it for bigger purchases.

For today, though, we’re going to talk about how your credit score is determined and how to ensure you have and maintain a good credit score.

My Credit History

I grew up with parents who taught me literally nothing about how credit works.  To this day, I think I’ve only ever had one conversation about credit with either of my parents. My mom told me how much she’d raised her score over a period of time. No details. Just that she did it.

Like most young adults who’d never had a credit conversation before, I had a rough relationship with credit in my late teens and early twenties.  I owned a couple of low-limit credit cards, which I abused and never paid off, and then I accumulated credit to buy a car (which I did pay off). Then I incurred some medical bills that I couldn’t pay because I was young and my earnings suuuuuucked.

For a long time, I refused to even do anything with credit because I’d messed it up so bad.  This was probably good for me. I lived on only the money I had in the bank from my mid-twenties until I turned twenty-nine.

That’s right, I lived sans credit through most of my twenties.  And it was good for me. Partly because I didn’t have an understanding about how credit works, every time I used it I was making my credit worse.

Around the time I decided I needed to buy another car and credit would be useful, I decided to get serious about my credit. I built it up from the high 500s to just over 800 where I sit today.

That is to say, I feel pretty good about my understanding of credit since I’ve been able to raise my credit score significantly over the last few years.  I don’t consider myself an expert, precisely, but I have a good idea of how the game is played. I feel well qualified to share the essentials of how credit works and how to take care of it.

Intro to Credit

Credit Bureaus

A common misconception among credit newbies is that credit bureaus provide credit scores.  This is usually not the case.  Credit bureaus simply capture credit information.  Each month your lenders report to the credit bureaus whether you’re paying on time and as agreed.

The three credit bureaus are TransUnion, Equifax, and Experian.  Many lenders report to all three bureaus, but some lenders only report to one or two of them.

Score Brands

Here’s what’s interesting about credit:  people think they have “a” credit score.  You have a lot of credit scores!  In fact, different brands even run numbers according to their own formulas for lenders.  For example, Fico and VantageScore are very popular score providers.  What these score providers do is pull your credit reports and run various formulas based on the data in the reports to come up with various numbers.

More than that, you can have one credit score for credit card lenders, one for auto loan providers, another for a mortgage loan provider, and one of each of those for the credit information from each bureau!

Not only this, but every few years they even change these formulas, so the Fico Auto Loan Score 4 is the previous generation of the Fico Auto Loan Score 5, and so on.  But, some lenders can still be using older formulas. One auto retailer may be pulling your Auto Loan Score 4 while another might be pulling your Auto Loan Score 8.

Because you can have so many credit scores, it’s silly to try to chase your exact score.  Instead, you should focus on making the information in your credit report as positive as possible. It’s sufficient to have a “fair idea” what your score looks like—are you in the mid 700s?  High 600s?  Low 500s?  This is about as accurate as you can really get.

What is a Good Credit Score?

Some brands will run scores from a credit score range of 300-850, while others will run numbers from 300-900, or even higher.  I’m not really sure why scores don’t start out at 0 and go up from there.  Why not 0-1,000?  Or 0-500?  No idea. Personally, I think we need a metric system of measurement for credit scores.

For the sake of providing examples, we’re going to use Fico’s range to illustrate points in this post. There’s no good reason for this choice. I just chose it because it’s a very popular score brand and because it’s the one I’m most familiar with.  Fico’s scores range from 300-850.

What’s a good credit score?  It depends on whom you ask.  I read once that the best credit score is the one that allows you to get the best interest rates when you’re ready to use your credit. I think that’s a good rule of thumb.

In general, though, credit scores can be roughly viewed this way:


It may also be worth noting that according to Experian, the average VantageScore for Americans is 688 and the average Fico score is 703.  For whatever that’s worth.

Credit Reports

Credit reports are the lifeblood of your credit score.  They contain the information that score providers will use to formulate their scores, so it’s important that the information in these reports is accurate and positive.

Obtaining Your Credit Report for Free

If you want to get your credit reports, you will need to purchase the information from the credit bureaus, but there are two exceptions:

  1. If you’ve been denied something because of your credit score—a loan, a job, a credit card, an apartment—you are entitled to receive a copy of the report that was used to make a decision on lending you credit or giving you a job—meaning you’ll get access to one of your credit reports.  When you are denied, you will receive a letter from the company that denied you.  That letter will provide details on how to retrieve a copy of this report.

  2. You are allowed to pull one free copy of your report from each bureau each year.  Do not get sucked into scam sites.  There is only one place to get your free report from each bureau each year.  To retrieve your free reports, go to www.annualcreditreport.com.

If you have never retrieved your free credit reports, I recommend getting all three the first year, and then getting one every four months in subsequent years.  This way you can keep an eye on the contents of your reports on a rolling basis. That’s the best practice for catching fraud and identity theft early.  Simply set up a calendar reminder in your phone or e-mail.

Reviewing Your Credit Reports

When reviewing your reports, your sole goal is to ensure that the information in them is accurate.  Remember that not all creditors will necessarily report to all three credit bureaus, and some won’t report at all. So you may not see every line of credit on every report.

Make sure you’re checking the addresses in your credit report, your phone number, date of birth, and of course, the contents of your report.

Each report will contain the name of your creditor, along with history for up to the last seven years of payments.  The amount of your payment each month will not be noted; rather, you’ll usually just see a color that indicates that payment was made on time, or an “OK” for each month.  You may see some other form of notation, but this would be less common.  Just be sure to check the legend on your report.

If payment was not made on time as agreed, you may see a “30,” “60,” or “90” in the slot during a month and year where the payment was missed.  This is negative and severely impacts your score.

If you see a “CO,” this stands for Charge Off and means that the creditor has given up trying to collect the debt from you.  This is a very negative thing and impacts your score as well.  The creditor has likely sold the debt to a collection agency.

It takes a minimum of seven years for negative notes on your credit report to drop off. Protect the contents of your report by contesting misinformation and by making your payments on time every month.

If you see anything suspicious on your report, such as accounts you never opened, this is a strong indicator that you are a victim of identity theft. You should immediately contact the credit bureau for next steps.

Maintaining Your Credit

As I mentioned, your credit score will be determined off various formulas by different providers. However, the way you maintain your high credit rating is the same regardless and usually consists of just a few different factors. Each score provider will weight the factors according to their own reasoning.

Payment History

Your payment history is usually one of the two highest weighted factors that make up your credit score.  It’s important to understand that your creditors don’t necessarily have to be lenders.  Some phone service providers will report your credit when you miss payments for services rendered, and so will some property managers.  Hospitals and other medical facilities will also report, but usually only when you miss payments.

If you think you might have to miss a payment or pay late, call your creditor and ask them to delay reporting until you can make a payment.  Many creditors and providers will work with you if you make a promise to pay or work out a payment plan to catch up.  The worst they can do is say no, so it never hurts to try when you know there will be a problem.

If you are good at making your regular payments, some providers will even call you before they submit a negative credit report for the month.  This happened to me once.  I always, always, always pay my rent on time or early, but one time I missed my rent on accident. (I forgot to hit the final “submit payment” button on the website.)  Because my payment history with my property manager was so positive, they knew this was out of character and so they called me before they took any adverse action.  I was able to go back in and submit my payment, even though my rent was about three weeks late at that point. They didn’t even charge me any late fees.

Credit Usage

Credit Usage is the other heavily weighted factor in your credit score.  Your credit usage is the ratio of credit you’re using against how much credit is available to you.

For example, if you have two credit cards, one with a $7,000 limit and one with a $3,000 limit, then you have $10,000 in credit available to you.  Now let’s say that between the two cards you have balances totaling $2,000.  This means that your credit usage is 20% (2,000/10,000).  So:

Credit Usage = Total Credit Used / Total Credit Available

Generally speaking, the lower your credit usage, the better.  Most score providers recommend keeping your total credit used to under 30%. However, I recommend keeping your combined revolving credit balances capped at whatever you can pay off in a month. And it’s better if you pay off your credit card balances in full every month.

Credit Mix

Your score is supposed to tell the story of how well you’re able to use credit. Unfortunately, it’s not based on whether you are able to take on new credit judiciously, which I recommend. So it’s usually better for your score if you have a mix of revolving credit (credit cards) and loans, such as student loans, auto loans, mortgage loans, etc.

Personally, I think this is stupid, because that means in order to have a perfect score you’d likely need to have a loan recently on your account, even if you haven’t needed a loan in many years.  But, this is what it is.  Some people will finance a small portion of a large purchase they were intending to make just to keep a loan on their report. But I would only do this if you’ve already set aside the money to pay it off, and then pay it off relatively quickly. You’ll avoid paying more than necessary in interest.

Credit Age

Have you ever heard someone say to never close out a credit card, even if you don’t use it anymore?  That’s because it affects the average age of your accounts.  Let’s say you have three accounts on your credit report.  One is four years old, one is five years old, and one is nine years old.

The average of all these accounts is six years, which will be your average account age.  Credit score providers weigh the length of your credit history, though not as heavily as some other factors.  Still, closing an account can affect your credit age negatively and can drop your score.  So even if you don’t plan to use a card any longer, keep the account open if you can.

The other reason closing an account could affect your score is because it lowers the total amount of credit available to you. And, if you are using any credit, it will also increase your debt-to-credit ratio.

For example, if you have $10,000 in credit available to you and you’re using $2,000 of that credit, you are using 20% of your available credit.  If you were to close a credit card with a $2,000 credit limit, you now have $8,000 available credit and you’re using 25% of that credit.

Recency

The other age-related factor is how recently and frequently you’re opening new accounts.  Typically, a “hard inquiry” on your credit knocks a few points off your score. When you open several accounts in a short period of time, this can damage your score.  Hard inquiries typically drop off—or are no longer considered—after two years.

A “soft inquiry,” such as the type run when a credit card company “pre-approves” you for a card doesn’t affect your score. Credit card marketing teams use these to send you junk mail. Creditors will also sometimes run soft inquiries to provide you line of credit increases.

The best way to keep your recency and age in good health is to seek new lines of credit only when you need them. You should also keep revolving accounts open as long as possible.

Wrapping Up

There is so much more that could be said about credit. But I hope this introduction has broken it down for those who are new to understanding what credit is and how credit works.

If you’re new to credit, what is something you learned that you didn’t know?  If you’re a credit veteran with an 800+ credit score, what else do you think a new adult needs to know about how credit works?  Let me know in the comments.



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