How Credit Works: Understanding Your Credit Score

How Credit Works: Understanding Your Credit Score

April 2, 2020
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If you're wondering how credit works, you probably are interested in your credit score and its impact on lending decisions.

Every American has the right to a free credit report each year from the major credit bureaus – Equifax, Experian and Transunion. Your credit report helps you get a sense of where you stand with your past and current credit accounts.

The way you handle your financial accounts contributes to your overall credit score. If you're wondering how credit works, take a look at this guide to understanding your credit score.

How Credit Works

Though the credit scoring process can seem very secretive, there is a formula to determine your score. Learning this system is one of the best ways to understand how credit works.

Creditors evaluate your creditworthiness based on your tendencies to keep your financial agreements or skip over your responsibilities. Borrowers who demonstrate a solid payment history over time and shy away from overspending will have the best credit scores.

To better understand this concept, take a look at the top five major components of your credit score.

Payment History

By far and away, the leading factor in your credit score is your ability to make on-time payments. Late payments can cause a major dent in your credit score because payment history makes up around 35% of your score.

Keep in mind that all late payments aren't created equal. Most creditors won't report a late payment until it's 30 days behind.

Other creditors, like utility companies and landlords, may not report your payment history at all which can be a disadvantage if you have a history of paying on time.

Credit Utilization

Managing your money well is key. Creditors judge your level of financial responsibility by judging the amount of money you owe against the amount of credit you have available.

Maxing out your credit cards, for example, is one way to demonstrate to creditors that you don't understand how credit works. The creditor extends you temporary access to funds to hold you over until you can pay in full.

Credit cards used as long term personal loans can be to the detriment of a credit score. Use less than 30 percent of your overall available credit to keep your credit score strong.

New Credit

Applying for too much credit at once can have a negative impact on your credit score. One exception is when you are shopping for one specific type of loans, such as with a car loan or mortgage.

Opening too many cards at once is a sign of financial distress which can make you appear less creditworthy.

Length of Credit History

The tricky thing about credit is that you have to have credit accounts in order to build your financial reputation, but applying for new credit can lower your score. Keeping an account open shows your ability to manage money long term.

Avoid having inactive accounts closed by using your credit card from time to time to cover small purchases.

Types of Credit Used

One of the best-kept secrets of your credit score is how certain types of accounts affect your score differently. A rule of thumb is to mix up the types of credit accounts you own to help increase your score.

Your credit score can increase or decrease with too many of one account type.

Increase Your Buying Power

The best reason to learn how credit works is to increase your buying power for the important things in life. When it comes time to buy a house, for example, you want access to the lowest possible interest rate which is determined by your credit score.

At various milestones in life, you'll need to leverage your credit to get to the next level – and good credit can help open doors to the capital you need.

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