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How Does Credit Work? A Quick Guide to Understanding Credit

Esusu • August 25, 2021

Pressed for Time? Here’s a summary.

Credit and debt are two sides of the same coin. Debt is money you owe. Credit says how much you’re able to borrow. 

In the U.S., your credit is everything. It affects your ability to afford an education, car, rent or buy a house. It can even impact your healthcare premium! 

How creditworthy you are or how likely you are to repay a loan is evaluated and predicted using a credit score. There are tons of credit scoring systems out there, so don’t worry about slightly different numbers. 

Credit scores are calculated based on your credit history, which is summarized in your credit report. Credit bureaus make credit reports and you’re entitled to see yours for free every 12 months.  

Introduction

We get it. Credit is boring, confusing, and scary. This guide is meant to be a general overview of the subject. A “get-to-know-the-game” type thing to help you feel less overwhelmed the next time you think about credit.

Maybe it’ll help to think of credit as a game. A very high-stakes game that everyone would want to take seriously. 

 

Why is credit important?

Credit is a bit like plastic: everywhere, in everything, all the time. No seriously. Look at all the things your credit can affect:

  • Student loan with private lenders (NOT government loans)
  • Renting an apartment
  • Employment
  • Home / renter’s insurance interest rates
  • Mortgage qualification and interest rate
  • Car loan interest rate
  • Car insurance premium 
  • Car lease qualification
  • Healthcare insurance premium
  • Credit card qualification and interest rate
  • Size of initial deposit when buying a smartphone, or starting cable services and utilities

That’s right. Credit impacts the very foundations of our life. So what the heck is it? 

 

What is credit?

Credit is a sexy term for the other side of debt. 

Debt

You know what debt is. It’s a loan or borrowed money that hasn’t been repaid yet. For example: When you borrow $300 from a friend, it means you’ve taken on $300 worth of debt. Debt usually must be repaid with interest, for two reasons:

  1. To compensate the lender for taking on the risk to lend you money. After all, you may not repay it.
  2. To encourage you to repay the debt quickly. Otherwise, you might end up owing more money than you took out. 

Credit

Credit, then, is your ability to pay back that loan. It’s the amount of money you’re able to borrow based on your reputation of repaying debt. This is what being creditworthy means—you can be trusted to repay your debt when given a loan.

 

What’s credit score, credit history & credit report? 

In the U.S., a credit score is like a grade that assesses your ability to repay debt. When you apply for a loan, lenders use it to evaluate your riskiness or how likely you are to repay the loan. There are tons of different credit score systems, so it’s normal to have slightly different scores*. The most popular one is the FICO score (or Fair Isaac Company score). This is a number that runs between 300-850. 

The higher your number, the less risky you look. This means you’re more likely to qualify for loans and you’ll pay a lower interest rate. If you look more risky (have a lower number), you might have a harder time getting loans and may need to pay higher interest rates for it.

Your credit score is calculated based on your credit history, or a record of past loans and repayments. You credit history is usually summarized as a credit report**, which includes information such as:

  • If you’ve paid your bills on time 
  • Your current amount of debt and how much available credit you have
  • Your credit history length
  • Your credit accounts and any new credit accounts (too many is considered a bad sign)
  • Other important credit information, such as bankruptcies and foreclosures

Banks and other financial institutions, such as credit card companies and private student loan firms, use your credit report and your credit score to decide whether you qualify for a loan, how much to lend you, and your interest rate. Some landlords use it to decide whether or not to rent you an apartment. 

 

Notes: 

*Different credit scores are okay. In fact, it’s pretty normal to have slightly different scores across agencies because each uses a different formula. However, if your scores are too different from one service to another, you might want to check your credit report. Someone might have stolen your identity or there might be a mistake in your report

**Credit bureaus prepare your credit report. In the U.S., there are three credit bureaus: TransUnion, Experian, and Equifax. You can get a free credit report every 12 months from these three companies. 

 

How does credit work?

Putting it all together, the system works something like this:

Whenever you make a payment on a credit card or an education loan, that lender reports it to the credit bureau. In the U.S., there are three: TransUnion, Experian, and Equifax. They collect your payment histories and summarize it in a credit report. They also send all your credit data to scoring agencies, such as FICO score and VantageScore. These agencies use it to calculate your credit score.

Now when you go apply for a loan or to open a new credit account, that lender goes to the credit bureau and requests your credit report. They go to the scoring agencies for your credit score. Your credit score and credit report is used to determine if the lender wants to lend you money and how much. 

Credit and debt work together. Anytime you take out a loan, you are incurring debt. When you repay that debt (on time and in full), you are building your credit or your reputation to repay debts.

This can feel like a catch-22, especially for those with zero or little credit history. You must borrow to borrow. For example: If you need to take out a loan to buy a car, you must first have a track record of timely debt repayment. Otherwise, it is unlikely lenders will lend you money for such a big purchase.

Luckily, there are a number of things you can do to start building a healthy credit history. You can apply for a secured credit card, retail store credit card, or take out credit builder loans. 

 

What kind of credit is there?

To round out this quick guide, let’s talk a bit about the main kinds of credit that’s good to know about. There are two main ones.

 

  1. Installment Credit

Typical examples of installment credit are car, home, and personal loans. This is the kind of loan where you repay over a set period of time in fixed amounts, usually as monthly payments. The amount you repay each month depends on the interest rate and other repayment terms and fees. Your credit report and score would determine your interest rate and other terms on installment loans.

 

  1. Revolving Credit

This is what retail and bank credit cards run on. Usually, there’s a credit limit, a minimum monthly payment amount, and interest. You decide when you want to repay and how much. Interest is charged on whatever you don’t pay from month to month. Not having to pay off your full balance each month is what makes this credit “revolving.” 

Working with revolving credit can be tricky. Depending on how you use your revolving credit, creditors will categorize you as a transactor or revolver.

 

Be a transactor. You want to be a transactor, meaning you’re someone who pays off your balance in full each month. This ensures you’ll never pay the interest rate and you’ll show up in credit reports as highly creditworthy. In other words, being a transactor can boost your credit score. 

Avoid revolving. Being a revolver means only paying the minimum balance or a portion of the balance each month. Interest will be charged on your remaining balance, meaning you’ll pay more than you originally borrowed. If your spending outpaces your payments, your debt can skyrocket. If you suddenly lose your income or have an unexpected large expense, you may not be able to keep up with payments and become a delinquent payer. This will make you look less creditworthy and lower your credit score.

Wonder how these two kinds of credit came to be? Learn about it in our two-part series on the (brief) history of consumer credit. 

 

How do I protect my credit? What are my rights?

Stay up to date with your credit by getting your free annual credit report. Check to ensure there are no mistakes or inaccuracies, such as:

  • Information about you from a long time ago (more than 7 years ago)
  • Incorrect information about payment history and accounts
  • Accounts you did not open
  • Someone else’s information appears in your report

While there is no free annual credit score, some companies and banks might give you access to your score. However, remember credit scores vary from company to company. Just keep an eye out for wildly varying scores.

 

There is a law that protects you from credit discrimination. The Equal Credit Opportunity Act makes it illegal for creditors to discriminate against you on the basis of: 

  • Race
  • Color
  • Religion
  • National origin
  • Sex (sexual orientation and gender)
  • Marital status
  • Age
  • If you receive public assistance money

Lenders are not allowed to:

  • Refuse you credit if you qualify
  • Discourage you from applying for credit
  • Offer you less favorable terms when compared to someone with similar qualifications
  • Close your account

If you suspect you’ve been discriminated against, get legal help.  

 

Recap and Conclusion

With the basics and general rules under your belt, you’re starting to see that credit isn’t all that scary or complicated. 

The thing to remember when working with credit is to use what you know you can repay in full each month. This will help you avoid paying more than you borrowed and you’ll come across as a responsible credit user. 

Many companies have free tools and resources to help you monitor your credit score. The government also guarantees you can access your credit report for free once a year with each of the three credit bureaus.

 

References

“Credit reports and scores.” Consumer Financial Protection Bureau. Accessed July 16, 2021. https://www.consumerfinance.gov/consumer-tools/credit-reports-and-scores/

“Free Credit Reports.” Federal Trade Commission. Accessed July 16, 2021. https://www.consumer.ftc.gov/articles/free-credit-reports

Luthi, Ben. “How Does Credit Work?” Experian. August 3, 2016. https://www.experian.com/blogs/ask-experian/how-does-credit-work/

“Understanding Your Credit.” Federal Trade Commission. Accessed July 16, 2021. https://www.consumer.ftc.gov/articles/understanding-your-credit

Wood, Meredith. “How Does Credit Work? The internet’s Best Guide.” Fundera. Updated August 10, 2020. https://www.fundera.com/blog/how-does-credit-work

“Your Equal Credit Opportunity Rights.” Federal Trade Commission. Accessed July 16, 2021.

https://www.consumer.ftc.gov/articles/0347-your-equal-credit-opportunity-rights