Understanding How Credit Works

We’ve all heard the term credit score before, possibly many times (possibly too many times for some of us). It seems to run our financial lives and dictates many things from what we can borrow to how we pay things off to how big our purchases can be. But if we don’t know much about it, how do we let it run our financial lives so thoroughly?

In fact, it really pays to understand credit scores and how they work.

Companies use mathematical formulas, or various scoring models, to determine your credit score. This is analyzed from the information in your credit report, such as:

  • Your unpaid debt
  • Types of loans and how many you have
  • Your bill-paying history
  • Credit utilization
  • Applications for credit
  • Hard inquiries on your credit
  • Debt, foreclosures, bankruptcies

There are many other potential factors included, but these are the most notable and can determine the weight of the score. There are different types of scores and scoring institutions, but most of them range from 300-850, with 300 being the lowest and 850 the best. A higher score makes it easier to get loans and usually better interest rates.

Institutions and companies use credit scores to determine if they’ll offer you a mortgage, credit card, auto loans, student or business loans, or any other credit products. They also use the information to determine your credit limit and the type of card you can receive. While we speak of a credit score in the singular, there are potentially many different scores from different institutions and raters of varying recognition and stature. Credit can also vary from the scoring model, and change frequently. One of the most famous, for example, is the FICO score.

So how much control do we have over our own credit score?

Ways to Boost Your Credit Score

The best thing you can do for your credit score is to pay all your bills on time, including for any loans you might have. Easier said than done of course, but managing a payment schedule and being responsible with money are excellent ways to make continued, on-time payments that boost your credit score in the long run.

There are a certain few landmines that can absolutely demolish a good score and ruin credit history for months, possibly years or longer if not handled properly. Bankruptcy, defaulting on loans (such as student loans), not paying bills on time or at all, having a car repossessed, and other events are the quickest ways to ruin your credit score. While it may not seem like a big deal at first, these events and their resulting credit score hits can seriously disrupt your ability to get a loan for something you want in the future, such as a mortgage, a business or auto loan, or any type of product involving credit history, which is a considerable amount in the modern world.

In short, avoid those events like the plague.

If you have loans, pay them on time, in full. If you have credit card debt, pay it on time, and pay off the cards as soon as you can—but don’t necessarily close the card once you do, as that can also hurt your credit score. Budget well and pay your bills; don’t rack up frivolous purchases on your cards, and avoid overspending on wants instead of needs.

When you check your credit history report, look for inaccuracies; if you find them, report them and have them fixed. Have hard inquiries removed, if possible. If you see particular hits to your score, work on those first and foremost. If you have no score or want to boost an old or inactive one, you can be added as an authorized user to another account with perfect payment history and have your own score boosted (usually done by a friend or a relative).

Credit utilization, or the portion of your credit limit that you’re using at a given time, is another large factor on your credit report. Many places recommend trying to keep it at 30% or less of your total credit limit (less is best). The best way to achieve this is to pay your credit card balances on time and in full every month. If you have trouble maintaining this number, you can ask for a higher credit limit while keeping your spending stable.

Maintaining Good Credit

Once you have a general picture of your credit history and score, and have begun grappling with the day-to-day ways to improve your score, you can start planning out your financial history and credit boosting in more detail. For instance, if you have old credit accounts, keep them open instead of closing them. Longer credit histories are more appealing to lenders. Make sure the accounts are paid off in full, however, and maintain consistently good credit on all of them.

If you have many outstanding debts, you can consolidate them using a bank. This can help you get a better interest rate that is easier to pay down over time, which helps both your credit utilization and your overall score. You can also use a balance transfer card to pay off multiple credit card balances at once. If you’re unsure of the best path forward here, don’t be afraid to consult your bank or a financial advisor.

In general, credit scores are similar to other barometers of financial health in that they not only show how others rate us on our payments, but areas we can overall improve. It’s never a bad idea to budget better, save more money, pay off bills quicker, and prioritize needs over wants in our spending. Similarly, if our spending habits are all out of whack, a credit history report is a good way to see where we can improve that generally and how it’ll help our financial lives in the future, especially when it comes to large things we’ll want like houses, cars, or possibly student and business loans.

Understanding our credit and our money is an important skill that can only help us. Whether we learn the hard way or understand it right off the bat is less important than making sure we set healthy, beneficial financial habits for ourselves to serve in the lon