Credit is essential in today’s financial landscape for reaching your goals, whether they are buying a home, starting a business, or simply having a safety net for unexpected needs. But what is credit and why is it so important? This blueprint will demystify the world of credit, giving you a foundational understanding of credit and then help guide you through how to build credit and maintain it.
I. Understanding Credit
What is Credit?
Credit is a tool that allows people to borrow money now and pay it back later. It essentially operates on a trust system where the lender allows the borrower some amount of money or “credit” and believes that at some point in the future, the borrower will pay the money back (usually with interest). Although that doesn’t always happen in such a simple manner, that’s the whole concept in a nutshell. And credit can take many forms such as credit cards, loans for cars or houses, and other lines of credit which are usually tailored to a specific need or situation.
Types of Credit
You may ask, what are the types of credit? Well, at its core, there are three different types of credit: revolving, open, and installment but there are so many credit products these days that are based on these core types of credit. Here’s a quick hit list of some of the more common types of credit products:
- Credit Cards: Credit cards are the most common form of bank credit. An issuer provides you with a revolving line of credit which allows you to make purchases up to a limit known as your “credit limit”. As you spend money on your credit card, you use up more of your credit line and when you pay it down, you free up more of that credit line. As a borrower, you can pay the balance in full at the end of the month or make a minimum payment (with interest).
- Personal Loans: Personal loans are considered unsecured, meaning they don’t require collateral, that individuals can use for various reasons such as consolidating debt, covering unexpected expenses like medical bills, or even funding recreation like a vacation. These loans usually have fixed interest rates and repayment terms.
- Mortgages: Mortgages are longer-term loans that are used to purchase homes. These types of loans usually span from 15 to 30 years for the more common loans and have either fixed or adjustable interest rates. The loan is considered secured because the home is the collateral and the lender can foreclose on the property if the borrower fails to make their payments.
- Auto Loans: Auto loans are specific loans used to purchase… you guessed it – automobiles! The car is often the collateral for the loan which also makes this type of loan a “secured” loan. The terms and interest rates can usually vary depending on the lender.
- And there are MANY more!
Benefits of Using Credit
Now that you have a basic understanding of credit and the types of credit products, you have to ask: What are the benefits of credit or why would I use it?
Using credit in the smart and right way can offer several advantages to you as you’re building wealth and finding financial freedom:
- Building Credit History: Responsible credit use helps you build a better (higher) credit score which is important for securing favorable terms on future loans or credit cards.
- Earning Rewards: Many credit cards offer rewards (usually based on a percentage of your spending), such as cashback, points, or miles on your purchases. Using a credit card for everyday expenses can result in valuable rewards over time. Especially if you pay off the balance every month so you’re not paying interest, this could be a nice little bonus to your budget.
- Financial Flexibility: Credit can provide financial flexibility when dealing with unexpected events or emergencies.
- Safety & Convenience: Credit cards are generally considered safer than carrying large sums of cash, and they are widely accepted for online and in-person transactions. These days, you can even save your credit information on your phone and leave the plastic at home.
II. Credit Score Basics
What is a Credit Score?
A credit score is a three-digit number that indicates how “credit-worthy” you are. It is an important factor in determining the interest rates you’re offered on loans, the credit limit (how much you can spend) on your cards, and even your ability to rent an apartment or land a job. The most common scoring models use a range of 300 to 850 with higher scores indicating better creditworthiness. You can think of this as your borrowing report card grade. The higher the score, the better candidate you are in the eyes of lenders.
Why is a Credit Score Important?
Your credit score is a financial report card that lenders, landlords, and even employers use to evaluate your trustworthiness. A good credit score can open doors, granting access to loans at lower interest rates and helping secure favorable rental or employment terms. Generally, the higher your credit score, the better the interest rate you will receive.
How do Lenders Use Credit Scores?
Lenders use your credit score as a primary tool for assessing risk. They consider various scoring models, with the FICO score and VantageScore being the most commonly used. These scores help lenders, like banks or credit unions, determine the likelihood that a borrower will default on a loan (not be able to pay them back). Higher scores translate into lower risk for lenders, which typically results in better loan terms for borrowers.
III. How Credit Scores Are Calculated
- Payment History: Making on-time payments has the most significant impact on your credit score. Even a single missed payment can lead to a drop in your score so be sure to keep track of your payment dates or set up autopsy.
- Credit Utilization (the amount you use): Credit utilization is the ratio of your credit card balances to your credit limits. For example, if you have a $1000 credit limit and you utilize $300 of that limit, you would have a 30% utilization rate. In general, you want to aim to keep this ratio below 30% to maintain a positive score.
- Length of Credit History: The length of time your credit accounts have been open affects your credit score. Generally, a longer credit history, the more favorable of an effect it would have on your score.
- Type of Credit (your mix): Although it’s not required to have more than one type of credit, a diverse mix of credit accounts, such as credit cards, installment loans, and mortgages, can have a positive impact on your score.
- New Credit Inquiries (new credit you apply for): Opening multiple new credit accounts within a short period of time can lower your score. For lenders, this may suggest financial instability or overextending yourself.
Credit Score Ranges and Categories
- Exceptional (800-850): Individuals in this category are very likely to receive the best credit terms available.
- Very Good (740-799): Borrowers in this range enjoy favorable terms and are generally seen as low-risk.
- Good (670-739): A good credit score opens doors to decent loan terms, but may not secure the very best rates.
- Fair (580-669): Borrowers in this category may face more limited credit options and higher interest rates.
- Poor (300-579): Individuals with poor credit may struggle to obtain credit or loans, and those offered may come with high-interest rates.
IV. Building Credit
Establishing Credit History
If you are new to the world of credit or fixing a bad one, establishing a good credit history is the first step. Lenders rely on your credit history to assess your financial responsibility and reliability.
Secured Credit Cards
Secured credit cards are an excellent starting point for building credit. These cards require a cash deposit as collateral, often equal to the credit limit. The deposit reduces the risk for the lender and provides a safety net for the borrower. Over time, responsible use of a secured card can lead to unsecured credit card offers.
Authorized User Accounts
Becoming an authorized user of someone else’s credit card account can be a stepping stone to building credit. When the primary cardholder has a positive credit history, it can positively impact your credit as well. However, it’s essential to choose an account where the primary cardholder maintains responsible credit habits, as their mistakes can also affect your credit. Personally, my mom added me on her card as an authorized user (some issuers will allow users as young as 13 years old) and I ended up leaving high school with a credit of around 700. It was a huge boost and a nice surprise at graduation!
Credit builder Loans
Credit builder loans are designed explicitly for building or rebuilding credit. These loans are usually offered by credit unions and community banks. The unique aspect of credit builder loans is that the borrowed amount is held in a savings account or certificate of deposit (CD) until the loan is paid off. You can set up monthly payments so you don’t miss a payment. Credit builder loans help you build credit by reporting monthly payments to the three credit bureaus – Experian, TransUnion, and Equifax. If you want more details on how to get started with credit builder loans, check out this article.
V. How Do I Manage Credit Wisely?
Responsible credit card use is fundamental to maintaining a healthy credit profile which involves:
- Pay your credit card balance in full every month to avoid interest charges.
- Avoid late payments, which can lead to late fees and damage your credit. Set up auto-pay!
- Keeping your credit utilization below 30%. High credit card balances relative to your credit limit can hurt your credit score.
Paying Bills on Time
The single most significant factor affecting your credit score is your payment history. Missing payments, even by just a day, can lead to late payment notations on your credit report and a decrease in your score. Setting up automatic payments or reminders can help ensure you never miss a due date.
Managing Debt
Credit can be a double-edged sword. While it can help you access the funds you need, excessive debt can harm your credit score. It’s essential to manage your debt wisely:
- Aim to pay down high-interest debt first, such as credit card balances. If you have a large amount of outstanding debt, get on a budget (learn more about budgets with this article), and work to bring down those balances by using the debt avalanche method or even the debt snowball.
- Avoid closing old credit accounts, especially if you’re planning on taking a loan soon, as this can negatively affect your credit utilization ratio and average account age.
- Consider consolidating high-interest debt with a lower-interest personal loan to make repayment more manageable. Please keep in mind that this isn’t solving your debt issue but it may help reduce monthly payments and give you some breathing room.
Monitoring Your Credit Report
Regularly reviewing your credit report is vital for maintaining a healthy credit profile. You’re entitled to a free copy of your credit report from each of the three major credit bureaus (Equifax, Experian, and TransUnion) once a year. You can request your free annual credit report from AnnualCreditReport.com. Be sure to review your credit reports for accuracy and confirm that there are no unauthorized accounts or suspicious activity. If you find errors, dispute them with the credit bureau to have them corrected immediately.
VI. Maintaining a High Credit Score
Tips for Maintaining Your Credit Score
Maintaining a high credit score is a long-term commitment. Here are some tips to keep your credit in good shape:
- Keep your credit utilization low. Aim for a utilization rate below 30%.
- Avoid unnecessary credit applications. Each application can result in a hard inquiry on your credit report, which can lower your score.
- Diversify your credit mix. Having a mix of credit types, such as credit cards, installment loans, and a mortgage, can positively impact your credit score.
Avoiding Common Credit Mistakes
Common credit mistakes can lead to score decreases or make it challenging to maintain good credit. Avoid the following pitfalls:
- Missing payments or making late payments. Set up auto pay and thank yourself later.
- Closing old credit accounts can reduce your average account age and negatively impact your credit score. This includes cards closed due to inactivity so be sure to use those cards once in a while to keep those accounts open.
- Ignoring your credit report. Regularly review your credit reports to catch errors or signs of identity theft. Ignorance is not bliss in this case. In fact, it could ruin you financially if you turn a blind eye to it.
Improving a Low Credit Score
If you find yourself with a low credit score, you’re not alone, and there are steps you can take to improve it:
- Pay down debt, starting with high-interest balances. You’re aiming for 30% credit utilization or below for healthy credit usage.
- Strategically ask for credit limit increases. If your outstanding balance stays the same but your credit line amount increases, you will immediately lower your credit utilization rate.
- Dispute errors on your credit report. Incorrect information can drag down your score.
- Pay off collection accounts. I get it, sometimes life can get to us and we end up falling behind on payments which occasionally ends up with a collections agency. These loans or lines of credit are a huge negative mark against your credit so you want to work with the collections agency to pay that off and sometimes the agency may be willing to stop reporting the debt which could help your score out.
- Get credit from your regular recurring payments like rent or utility bills. Although FICO doesn’t track things like this, there are reports that do and showing good faith with regular recorded payments can help out your credit score.
- Seek professional guidance if needed. Credit counseling agencies and financial advisors can provide tailored advice to help you rebuild your credit.
VII. Protecting Your Credit
Identity Theft and Fraud Prevention
Protecting your credit and personal information is crucial. Take the following steps to safeguard your financial well-being:
- Use strong, unique passwords for your financial accounts and avoid sharing sensitive information online.
- Establish multifactor authentication to add an extra layer of security. It’s a bit harder for hackers to get into your accounts if you have to receive a security code to your phone and type that code in.
- Consider saving your card information on a digital wallet and leaving your physical cards at home.
- Be cautious of phishing attempts. Scammers often pose as legitimate institutions to trick individuals into revealing personal and financial information.
- Enroll in a credit monitoring service like CreditKarma to get continuous monitoring of your credit.
- Monitor your credit reports for suspicious activity. Unexpected changes in your credit report can be an early indicator of identity theft.
- At the highest level, you could always put a freeze or alert on your credit report to stop new lines of credit from being opened. If you want more information on how to do this, check out this post by the FTC.
Free Annual Credit Reports
You can access a free copy of your credit report from each of the major credit bureaus once a year through AnnualCreditReport.com. It’s essential to review your credit reports for accuracy and signs of fraud. If you notice any errors or discrepancies, follow the dispute process to have them corrected. The FTC (Federal Trade Commission) has a short and simple guide you can follow here.
Credit Monitoring Services
Credit monitoring services are available for ongoing credit report updates and alerts. These services can provide peace of mind, particularly if you’ve been a victim of identity theft in the past. They offer real-time notifications of significant changes to your credit report, such as new accounts opened in your name or late payments reported.
VIII. Frequently Asked Questions
Common Credit Questions – Asked & Answered
Debunking Credit Myths
Explore and debunk some of the common myths and misconceptions surrounding credit:
- Myth #1: Checking your credit report will lower your score.
- This is a common misconception. Checking your own credit report is considered a ‘soft inquiry’ and does not impact your credit score. In fact, it’s a good practice to regularly review your credit report to ensure accuracy and address any issues promptly.
- Myth #2: I have to carry a balance on my credit card to build credit.
- Contrary to popular belief, carrying a balance on your credit card does not directly contribute to building credit. Responsible credit usage involves paying your full balance on time. Consistently paying off your credit card in full reflects positively on your credit history and demonstrates financial responsibility.
- Myth #3: Closing a credit card will improve my credit score.
- Closing a credit card can actually have a negative impact on your credit score. It may affect your credit utilization ratio and reduce the average age of your accounts, both of which are factors in determining your credit score. It’s generally advisable to keep your older credit accounts open, even if you don’t use them frequently.
- Myth #4: Paying off a collection account will remove it from my credit report.
- While paying off a collection account is a positive step and can improve your credit over time, it won’t automatically remove the entry from your credit report. The collection account will typically remain on your report for a certain period, but its impact on your score may lessen as time passes. Your best bet to try to get an early removal is to see if the collection company would be willing to stop reporting the account.
- Myth #5: It takes years to rebuild a low credit score.
- Rebuilding a low credit score is a gradual process, but it doesn’t necessarily take years. By adopting healthy financial habits such as making on-time payments, reducing outstanding debt, and responsibly managing credit, you can see improvements in your credit score over several months. Usually, the lower the starting line, the higher the jumps in progress will be. Consistency and positive financial behavior are key to the rebuilding process.
IX. Take Away
Mastering your credit is not just about achieving a good credit score; it’s about securing your financial future. Responsible credit management can open doors to opportunities, financial security, and peace of mind. Building and maintaining good credit is a long journey but it can be very beneficial and have a positive impact on almost every aspect of your financial life. Please use it responsibly.