How does credit work?
In this post, I’ll talk a bit about the most important parts of how credit works. But first, what is credit anyway?
What is credit?
Basically, credit is when you pay for something with borrowed money that you promise to pay back later. You can start building credit by opening a line of credit, usually a credit card but it can be a loan.
Your credit score is a numerical value assigned to you from the three major credit bureaus that is a shorthand for whether they think you can reasonably pay back new lines of credit. Credit scores range from 350 to 850. A “good score” really depends on the company or organization. I’ve seen 650 be sighted as a good score, while other companies want a higher score to offer you a new credit line. That being said, a lower than 650 credit score can use some work.
There are three credit bureaus: Experian, Equifax, and TransUnion. Usually, your credit at each place will be around the same, but I’ve had my score vary as much as 50 points between bureaus. When I went over my credit report with a financial advisor, she said they look at the middle score. These bureaus are the companies that gather and maintain the information that goes into your credit score, which we will be discussing below.
A great place to check your credit report is freecreditreport.com. Personally, I use Credit Karma to check my scores on a regular basis and then I use annualcreditreport.com to check my credit report once a year just to make sure everything on there looks good. Keep in mind, though, that your credit score isn’t all the information you need to determine your financial health. Think of it like your physical health; your weight tells you something about your health but not everything. Going to the doctor to get a physical (using annualcreditreport.com) will tell you more about your health than stepping on a scale (your credit score).
So, let’s talk about what is on your credit report, and thereby what information is used to make your credit score.
Hard & Soft Inquires
An inquiry is when someone checks your credit. When you go to a credit monitoring website, many credit card offer this service these days, and check your credit, that is a soft inquiry. It basically just means that your credit is being checked. The difference between this and a hard inquiry is that when your credit is checked when you are applying for a new line of credit, that is a hard inquiry.
Hard inquiries will lower your credit temporarily, while soft inquiries don’t affect your credit at all.
How long will a hard inquiry stay on your credit report, you ask? Usually between one and two years.
Now, I want to say that building and maintaining your credit is a marathon, not a sprint. So, it may seem like two years is a long time, but in the long run it’s not really. Also, each hard inquiry will only lower your score by about five points. So, if you need to request a hard inquiry, like when you’re getting a loan to buy a car, five points are really not that big of a deal. Especially when you can affect your credit in other, more significant ways. Like…
Payment History
Your payment history is the most significant factor in what makes up your credit score. It is SO important to make your payments on time and at least the minimum owed each month.
This is because for every late payment, it could decrease your score by as much as 100 points!'
Now, let’s define what a late payment really is to a credit bureau. Typically, if you pay your minimum the day after it is due, that is technically late. However, the company will not report your payment late to the credit bureaus until your payment is 30 days late.
That doesn’t mean that you can pay late with absolutely no penalties, though. A late payment can cause the credit company to increase your interest, for one thing. You could have to pay a late fee, for another.
Of course, in addition to paying the minimum on time each month, it’s even better to pay over your minimum, because…
Credit Card Usage
This is the second most important factor in determining your credit score; almost a third of your score is affected by this.
When we talk about credit card usage, we mean what percentage of the line of credit are you using. So, the $6600.00 I’m using from my credit card with a limit of $7200.00 means I’m using 92% of my credit on that card. Yikes!
However, my credit usage is actually 76% because of my other card that’s paid down. This is still pretty yikes but it’s MUCH better than almost 100%. What you and I really want to aim for is a credit usage of 30% or lower. This 30% is what the credit bureaus really look at when it comes to your usage when determining your score.
A trick is to determine what 30% of your limit is, and then treat your card as if that IS the limit. For example, since my actual limit for my card is $7200.00, I should treat it as if the limit is 30%, which is $2160.00. I have a while before I get there, but using the snowball method, which I talked about in the post How to pay down debt., will help me get there sooner.
I hope this brief rundown of the most important factors that make up your credit was helpful! Leave a comment below and let me know how your credit journey has been.
Talk soon, Madeleine