Credit is one of the most important aspects of a person’s financial life. Your credit score affects your ability to get loans, credit cards, apartments and more. There are several components to credit that have an impact on you and your financial situation. You can check these factors by looking at your credit score and credit report. In this article we’ll discuss the different types of credit, how credit scores work, how you can use the system of credit and more.
To get your credit and overall financial life in order, consider working with a local financial advisor.
What Is Credit?
Credit is the medium through which one’s personal ability to borrow money or access services with the understanding that you’ll pay back any loans or incurred costs is determined. Mortgages, auto loans, credit cards and certain utilities all rely on systems of credit. That’s because a company or organization is providing you with a good or a service in return for repayment and possibly interest.
However, there are other important factors to consider when talking about credit. Your creditworthiness, credit score, credit history and credit report comprise your overall credit profile. Credit is also used to determine interest rates when you borrow money, as those with a stronger credit past receive the best rates.
Types of Credit
There are a few different categories of credit, though they all follow the same general premise of using money, a good or a service with the expectation that you’ll pay for it at a later date, often while incurring interest. There are four main types of credit:
- Revolving Credit: This is how most traditional credit cards work. You’re handed a credit line and you’re expected to make payments towards your purchases on a regular basis. Anything you don’t pay off is carried over to the next billing cycle, and you’ll likely pay interest on that amount.
- Charge Cards: This type of credit is similar to a credit card, only you can’t carry a balance over to the next billing cycle. Instead, you have to pay your balance in full every month.
- Installment Credit: This is how most loans work, whether a mortgage on a house, an auto loan or a student loan. You borrow money from a lender and then are expected to pay it back in regular installments.
- Service Credit: Utilities, phone bills and certain memberships are considered service credits. More specifically, you use a good or service and pay for it after using it. Payments are typically made on a monthly basis.
Understanding Your Credit Score & Report
When you apply for a loan, credit card or another product that requires a credit check, you credit profile will come into play. The most important factors that affect the state of your profile are your credit score, report and history. Below is an overview of how these credit principles work.
Credit Report
Your credit report is the main item lenders will look at when determining your creditworthiness. Each of the three main credit bureaus – TransUnion, Equifax and Experian – have credit reports on file for individuals with any history of using credit. Your credit report includes detailed accounts of all your past and present lines of credit. Your credit utilization ratio, as well as any late payments or bankruptcies, will also show up on your report.
Generally speaking, you’re able to access one free credit report from the trio of credit bureaus every year. However, through April 2021, you can do this on a monthly basis. Your credit report is the most detailed way of looking at your credit profile and determining your probability of success when applying for a new line of credit.
Credit Score
The concept of a credit score is one many people become obsessed with. In short, a credit score is a streamlined way of understanding the quality of your credit report. Someone who doesn’t carry high balances on their credit cards, repays their loans on time and hasn’t missed payments or filed for bankruptcies will likely have a higher credit score than someone who has been less responsible with their credit.
Organizations such as the Fair Isaac Corporation, or FICO, use proprietary models to determine your credit score from your credit report and history. While a credit score is a good indicator of your creditworthiness, it’s almost never the sole determinant of acceptance for lenders. FICO credit scores are determined using the grading system below:
- Payment History (35%): This is the most significant contributor to your credit score. If you make late payments, your score will inevitably be hurt.
- Credit Usage (30%): How much money you owe on your credit lines also greatly contributes to your score. The more of your credit lines you use, the more your score is impacted negatively.
- Credit History (15%): A large amount of your credit score is determined simply by how long you’ve been using credit cards. Closing credit card and loan accounts that have been open for a long time can have a negative effect by decreasing the average length of credit history across all your accounts.
- New Credit Applications (10%): When you apply for new credit, you’ll get what’s called a “hard pull” on your credit report. Normally these aren’t much to worry about, although multiple hard pulls in a short period may raise red flags for lenders.
- Mix of Credit (10%): As noted above, there are four main types of credit. The more accounts you have across each of these credit types, the better your score will be.
FICO credit scores are determined through the use of a scale. The lowest score you can have is 300, while the highest is 850. To make this large range easier to understand, FICO has attributed descriptions for specific areas within it. They go as follows:
- Excellent: 800 – 850
- Very Good: 740 – 799
- Good: 670 – 739
- Fair: 580 – 669
- Poor: 300 – 579
Bottom Line
Understanding credit is extremely important for your overall financial health. It can help you pay for things on a month-to-month basis, while also making large purchases, like a home or new car, more accessible.
Your credit history, profile, report and score are all important factors when it comes to opening new lines of credit. Without a broad understanding of the factors at play, you could end up paying a higher interest rate or being denied credit altogether. When used properly, credit can help you reach your financial goals.
Tips for Building Credit
- Your credit score plays a big role in your financial life, and a financial advisor will take it into account when building your financial plan. What’s more, finding the right financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in just five minutes. Get started now.
- SmartAsset has compiled a strong library of credit card recommendations designed to help you find the right card for you. Whether you’re looking for a travel card, a balance transfer card or a general rewards card, we have options for you.
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