How Does Credit Work? A Guide to Taking Charge of Your Credit Profile
Understanding how credit works may help you build future financial success.
Contributing Writer at Tally
December 6, 2021
Credit is a tool that helps us finance purchases, but truly understanding how credit works escapes many of us. We might only know that we give a company our Social Security number and other information, and they pull some numbers to determine whether we’re approved for a credit card or loan.
Understanding more about the ins and outs of credit and why we’re approved or denied for new credit can help us build better, more secure financial futures.
So, how does credit work? We’ll explore all the specifics of what credit is, how it works and how to protect yours.
What is credit?
Put plainly, credit is your ability to borrow money from financial institutions or receive goods and services now but pay for them later.
Your credit typically falls along a spectrum: excellent, good, fair or poor. You can also have no credit if you’ve never financed anything or it’s been a long time since you have.
How does credit work?
With so many variables to consider, credit can be a little overwhelming. Let’s cover the basics.
There are many credit bureaus, but the three major credit bureaus that both creditors and consumers look to are Equifax, Experian and TransUnion.
Your creditors submit your account information to at least one of these credit reporting agencies, though most creditors submit to all three. Submitted account information includes your payment history, account balances, credit limits, minimum payments and more. Each credit bureau uses this information to create your credit report.
Your credit report is essentially your financial report card. It lists all your creditors, debt balances, credit limits, minimum monthly payments and payment history. It also includes any collection accounts you may have and any recent bankruptcies. In some cases, it includes your past names, aliases, addresses and jobs.
Your credit score is an important part of the answer to the question, “How does credit work?”
A credit score is a numerical score based on the information contained in your credit report. Numerous credit-scoring models are available, but the FICO score is the one most financial institutions use.
Your FICO credit score ranges from 300 to 850. The higher your credit score is, the better your chances of getting approved for loans with low interest rates and other favorable terms.
Five weighted variables impact your credit score. These factors and their impact on your credit score are:
Payment history: 35%
Amounts owed: 30%
Length of credit history: 15%
New credit: 10%
Credit mix: 10%
Each lender has its own formula for what it considers good and bad credit scores, but FICO has a commonly accepted ranking of credit scores:
580 to 669: Fair credit score
670 to 739: Good credit score
740 to 799: Very good credit score
800+: Exceptional credit score
A credit inquiry is when a creditor looks at your credit history. While all inquiries may show on your credit report, only hard inquiries will impact your credit score.
A hard inquiry is when a lender pulls your credit report to use what’s on the report to extend credit. The exact number of points a hard inquiry can take away from your credit score depends on many other factors.
A soft inquiry is when a creditor looks at your credit but no potential loan approval or denial is attached to the inquiry. Soft inquiries have no impact on your credit score.
Types of credit
You can get various types of credit, and each has its own purpose. These types of credit include:
Revolving credit: This type of credit is an open line you can use as many times as you’d like, so long as available credit remains. The most common type of revolving credit is a credit card account, but lines of credit such as home equity loans are also a form of revolving credit.
Installment credit: Installment credit is close-ended credit, meaning it has a starting date and an ending date. Great examples of installment loans include auto loans, personal loans, mortgages and student loans.
Service credit: If you have a postpaid cell phone or utilities, you’re dealing with service credit. You receive the service today, but you don’t pay for it until the following month. In years past, service credit didn’t show on your credit report, but some new scoring models include it.
Credit utilization plays a big role in your credit score, as it’s a major component of the amounts-owed variable. It is the total balances on your revolving credit accounts relative to their combined credit limits.
Credit utilization is expressed as a percentage. If you had a $500 balance on a credit card with a $1,000 credit limit, you’d have a 50% utilization rate.
While there is no hard and fast rule on what credit utilization ratio is considered too high — meaning, it’s high enough to start negatively impacting your credit score — many experts recommend keeping your credit utilization ratio at 30% or lower.
Why is building credit so important?
While learning how credit works can be complicated, it’s important to take the time to understand how a good credit score is beneficial to you. With a good credit score, you’ll have no problem getting financed for a car, home or other large purchase — and credit card offers will make your mailbox runneth over.
Your credit score may seem unimportant if you have no intention of ever financing anything, however, it plays a role in your life in several other ways.
Renting a home
If you plan to rent a house or apartment, the landlord will likely pull your credit score and credit report to see what shape they’re in. If you have a poor credit score and your credit report is filled with negative marks, there’s a good chance the landlord will move on to other applicants with superior creditworthiness.
If you have a good credit score, the landlord may look more favorably on your application and put you ahead of other applicants.
Some states have banned this tactic, but some car insurance companies use your credit score and report to calculate your insurance premiums. The lower your credit score and the more negative marks on your credit report, the higher your premiums may be.
When you have your utilities — such as water or electricity — turned on, many providers check your credit before opening your account. They use your credit score and report to determine whether to charge you a security deposit and how much of a deposit to charge.
With a good credit score, you may never have to pay a deposit for utilities.
Some companies, especially financial services companies, will check your credit before hiring you. They do this to assess the risk of you stealing from the company or accepting bribes because you’re overextended.
Poor credit history or the lack of credit history could get in the way of landing that job.
Why should you monitor your credit?
Credit monitoring is a way to get ahead of any potential issues proactively. Here are a couple great reasons to regularly monitor your credit.
A thief could get your Social Security number and open credit under your name or credit card number and run up the balance through various means. This can result in severe damage to your credit.
However, if you regularly monitor your credit, you’ll see the unfamiliar account the thief opened or see your balance skyrocket. At that point, you may be able to stop the fraud before it causes too many issues.
Sometimes creditors make mistakes in their reporting. Maybe you made your monthly payment, but the lender applied it to the wrong account. This can result in a negative mark for a late payment.
If you monitor your credit, you may catch this negative mark and dispute it before it can do too much damage to your credit score.
Where can you monitor your credit for free?
There are plenty of paid credit monitoring services, but you can also do it yourself for free.
Once a year, you can get a free credit report from all three credit bureaus from www.annualcreditreport.com. This is a full credit report that outlines all the key details any lender would see. If you find any discrepancies, you can dispute them with the specific credit bureau.
You can also sign up for any of the countless free credit score websites, such as Credit Karma or Credit Sesame, and watch for unusual activity on your credit report.
How can credit help your financial success?
Credit plays a huge role in your life, whether or not you plan on financing anything. Credit can help you get financing, and it can impact your housing, car insurance and even employment. This is why it’s so important to understand the details of how credit works: including your credit score, credit utilization and credit monitoring.
If your credit is suffering because of high credit card balances, check out the Tally† credit card debt repayment app. Our app can help you manage your credit card payments — and Tally offers a lower-interest personal line of credit, allowing you to efficiently pay off higher-interest credit cards.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.