What is Credit? - Understanding Credit

Credit can be confusing. You may be in a great place financially and have bad credit or struggling to make ends meet and have a great credit score. While it can seem like credit scores don’t really reflect your financial situation, there’s no escaping the reality that your credit score is important.

Because credit scores are important, it’s important for you to understand them and how they work. What determines your credit score, what does your credit score affect, and what steps can you take to improve your score?

How credit works

Before diving into the credit score itself, it's important to understand what credit actually is and how credit works.  Credit is essentially an agreement you have with a lender to borrow a specified amount of money to purchase goods or services that you agree to fully pay for at a later date.  It can come in many forms and used for many goods or services such as a vehicle, house, or even to pay for day-to-day expenses.

There are generally two types of credit: installment credit and revolving credit.  Installment credit is used to borrow a fixed amount of money that you agree to pay back to the issuer in equal installments over a fixed amount of time.  These are typically in the form of auto loans, mortgages, personal loans, or other types of credit requiring a fixed amount to borrow.

Revolving credit refers to a set amount you can borrow at-will when you need it.  Revolving credit is most commonly associated with credit cards where they give you a specified credit limit, and should you choose to use it, you can purchase goods or services up to the credit limit.  By using the credit card you have agreed to pay back the issuer from assets (typically cash) from your bank account on the next month's billing cycle.  Once you make your first purchase on a credit card, you can expect to receive a bill to at least pay your minimum payment but should ideally be paying off the statement balance in full every time you use it in order to maintain good credit and stay out of debt.

What is a credit score?

Credit scores are a numerical score, ranging from 300 to 850, that lenders often use to gauge your trustworthiness as a borrower. The higher your credit score, the more trustworthy you appear to borrowers.

Your credit score is generated based on the information in your credit reports. These reports contain information about how you’ve interacted with credit and debt in the past. Based on this information, and proprietary formulas, lenders can determine your credit score.

Who Handles Credit Scoring?

There are three major credit bureaus: Experian, Equifax, and TransUnion. Each keeps a separate file on your credit history and lenders can ask any or all of the credit bureaus for a copy of your credit report when they want help making a decision about a loan application.

Typically, each bureau will have similar information, meaning each report will produce a similar score, but sometimes, there can be small differences between each bureau’s report.

FICO Scores vs. Vantage Scores

It’s important to note that there are many different formulas for calculating a credit score. That means you don’t have a single credit score, you have many. Each lender and credit card company chooses the formula that it prefers to use.

Two scores you may have heard of are VantageScore and FICO Score. There are multiple models for each score such as FICO 8 and FICO 9. VantageScores are commonly provided by sites that let you check your own credit, but lenders tend to use FICO scoring models when making lending decisions.

The formula used can make a big difference in your resulting score. For example FICO 9 reduces the score penalty for having medical debt in collections.

Differences between FICO and VantageScore models

You can’t control the formula each lender uses, but you can work to control the information that appears on your credit report, which impacts your credit score.

What does your credit score affect?

Your credit score is so important because it affects so many aspects of your financial life.

The most obvious thing that your credit affects is your ability to borrow money.

When you apply for a loan, one of the first things the lender will do is check your credit report. Lenders want to know that they’ll get back the money they lend out. If you have a history of missing payments or defaulting on loans, few lenders will be willing to give you a loan.

Even if a lender decides to take a chance on someone with a low credit score, it’ll want some compensation for taking that risk. That means it’ll charge more fees and higher interest rates to borrowers with low credit.

The effect is that people with poor credit scores have trouble borrowing money and will find that their loans are more expensive.

A good credit score can save you a lot of money

With larger loans, like mortgages and auto loans, good credit can have significant implications.

Picture two people who want to buy a house. They each have to borrow $250,000. One has great credit while the other has passable credit.

The person with great credit might be able to get a thirty-year mortgage at an interest rate of 3.25%. They’ll have to pay $1,088 per month, or a total of $391,686 over the life of the loan.

The person with okay credit might have to pay 4.5% interest to borrow that same $250,000. They’ll have to pay $1,267 per month, or a total of $456,017 over the life of the loan.

The first person’s strong credit saved them almost $200 per month and about $65,000 over the life of the loan.

Your credit score can also impact other parts of your life. In some states, insurance companies can consider your credit score when setting rates for things like auto insurance or home insurance. You might also have to offer an upfront deposit when signing up for cell phone service or internet if you have poor credit.

The five factors that determine your credit score

There are five factors that play a role in determining your credit score. Building good credit means paying attention to each factor and making sure you handle your money well.

Payment history (35%)

Your payment history is the most important thing when it comes to determining your credit score.

This aspect of your score simply looks at the number of on-time payments you’ve made on your credit cards and loans and the number of times you’ve made a late payment or missed one entirely.

Each timely payment helps your score, and each missed or late payment hurts it. However, the impact of a single missed or late payment is far higher than the impact of a timely one. It can take months to repair your score if you miss a due date, so the most important part of maintaining good credit is making sure you don’t miss payments.

Amount of debt (30%)

This aspect of your score is broken down into two sub-factors.

The first is simple: how much debt do you have? The more that you owe, the harder it will be for you to repay any new loans you get. That means having higher balances will reduce your credit score.

The factor is your credit utilization. This is a slightly more complicated calculation that compares your debt to the total credit limits of your credit cards. To find your credit utilization, add all your credit card balances together, add your credit limits across all cards together, then divide your balance by your total credit limit.

For example, if you have three credit cards with the following balances and limits:

Balance

Limit

Card 1

$500

$5,000

Card 2

$2,000

$2,000

Card 3

$0

$1,000

Your credit utilization would be:

($500 + $2,000 + $0) / ($5,000 + $2,000 + $1,000) = 31.25%

The lower your credit utilization ratio, the better your credit score will be. Maxing out your cards can reduce your score. Common advice is to aim to keep your utilization below 30% if possible.

Credit age (15%)

Your credit age is also composed of two sub-factors.

One is how old your credit report is. You don’t get a credit report right when you turn 18. Instead, the credit bureaus only start tracking your credit history when you you first start to build credit with a loan or credit card. The longer they’ve been keeping track of your interactions with credit, the clearer the picture of your habits your report will give to lenders and the more experience you’ll have in dealing with debt.

As your oldest loan or credit card account gets older, you’ll naturally gain some points.

The average age of your accounts also plays a role in determining your credit score. Lenders like to see borrowers that form long-term relationships and that don’t bounce from card to card and loan to loan. The older your average credit card or loan is, the better it is for your score. Opening a new card every other month will reduce it.

New credit (10%)

Each time you apply for a credit card loan, the lender will likely ask one or more of the credit bureaus for a copy of your credit report.  Before applying, you can get your free credit report and credit score to see where you stand on Harvest Platform.

Credit bureaus take note when this happens, adding a credit inquiry to your credit report. Each inquiry on your report reduces your score by a few points.

The impact of a credit inquiry is reduced over time and inquiries fully disappear from your report after two years.

On top of the impact of credit inquiries on your score, new accounts drop your average age of credit, which will also impact your score.

Credit mix (10%)

Your credit mix looks at the different types of credit that you’ve had experience with. Student loans, credit cards, car loans, and mortgages are all different lines of credit, but each works very differently.

The more experience you have with different forms of debt, the better equipped you’ll be to handle a new loan. More diverse credit mixes can give your score a boost. If you’ve only ever had credit card debt show up on your credit report, your score will likely be a few points lower than if you had a more diverse mix.

Conclusion

Your credit score plays a big role in your financial life, determining the loans and credit cards that you can qualify for and how much you pay to borrow money.

Your credit score looks solely at how you’ve interacted with debt in the past to determine your creditworthiness. It does not account for your current financial situation, such as how much money you have in the bank or how much you make from your job.  If you would like to get a true understanding of your financial health, you can use the PRO Index, which helps to build wealth rather than just access credit.

Because your credit score looks only at the past and only at how you’ve used credit and debt, it’s important to make sure you always use credit responsibly, doing your best to avoid missing monthly payments and applying for loans you don’t need.

About the Author

TJ Porter is a Boston-based freelance writer who specializes in bank accounts, credit, and credit cards. He’s written for Bankrate, Credit Karma, MoneyCrashers, DollarSprout and My Bank Tracker, among others. In his spare time, TJ enjoys cooking, soccer, reading, and video games.

Harvest helps increase the net worth of the 99% through artificial intelligence and financial automation. To date, Harvest has refunded over $2M in bank fees and interest charges to its members with the ultimate goal of increasing the net worth of everyday Americans by $1 trillion by 2030. Our platform starts with providing immediate relief through bank fee and interest charge refunds, orients a member's financial health with our proprietary PRO Index, and keeps track of net worth over time aided by our suite of financial tools. Check out our 8-step guide on "How to Build Wealth from Nothing" to get started on increasing your net worth.

Disclaimer: Harvest is not providing financial advice. The content presented does not reflect the view of the Issuing Banks and is presented for general education and informational purposes only. Please consult with a qualified professional for financial advice.