A Beginner’s Guide to Credit
For many people, credit is an intimidating term. You know you need it, but you’re not exactly sure how it’s established, calculated, or used. We’re here to make it all a little easier to understand. Keep reading for more information on how to improve your credit and personal finances—while opening up more opportunities for yourself in the future. With this knowledge, we want to empower you to make smarter, more educated decisions regarding your financial future.
What is credit?
Credit is when a consumer borrows money in order to access goods and services in return of a commitment to pay later with interest (Experian 2016). Not all credit is created equal, however. Lenders take many things into consideration regarding credit for each consumer, which is why interest will vary from lender to lender.
Why use credit?
Credit is essential when it comes to making many financial investments. Having good credit can make it easier to make necessary purchases—like a house or car. It can also be useful when you don’t have enough cash to cover the cost of an emergency or unexpected expense.
Some of the Benefits of Credit Include:
- You can pay back back what you owe in payments
- Credit can help you out in the event of an emergency
- Using credit can help you build up your credit history
Who uses it? What’s it used for?
Credit is used by consumers and businesses and is distributed by credit lenders. Credit lenders are often financial institutions like banks and other financial services companies. Sometimes, individual stores or companies grant customers credit to help them pay for a product/service they are interested in.
Reasons Why Someone May Use Credit
People utilize credit to buy everyday items, finance major purchases, and fund emergencies. Some of the most common examples include:
- Everyday items like gas, groceries, and services
- Your education (or a child’s education)
- A new vehicle
- A new home
- An emergency expense
- An upcoming vacation
- Appliances or furniture
- Luxury items
Many credit lenders rely heavily on credit reports and credit scores to determine if a consumer is reliable enough for a new line of credit. These reports will also help them determine the amount of interest a consumer will have to pay. In order to keep your interest rates low and your opportunities high, it’s important to keep a good credit record and credit score.
What is a credit report?
When a consumer uses credit, it is tracked by the three major credit bureaus—Experian, TransUnion, and Equifax. Each bureau keeps a record of consumers’ credit histories in order to develop credit reports.
A credit report includes identifying information, trade lines, credit inquiries, public records, and collections information (Myfico 2016). Below is a breakdown of the sections on a credit report.
Not all the obtained information on a credit report is permanent. Bankruptcies remain for ten years, missed payments and many public records items will stay for seven years, and credit history requests stay for two years (Greenpath, 2016).
The credit bureaus supply this information to lenders, banks, insurance companies, collections agencies, and even landlords. Your credit report is used to determine your credit score.
What is a credit score?
A credit score is a 3-digit number that’s used to evaluate how responsible a consumer is in regards to credit. The credit score is based on a consumer’s credit report. A credit score consists of a consumer’s payment history, how much is owed, the length of history, types of credit, and how many new credits have been applied for (Myfico 2016). The credit bureaus evaluate this data and calculate the credit score. The score may differ by a couple of points, depending on the credit bureau. Credit scores are generated from many components of your credit report. Below is an example of what determines your credit score.
This tracks whether you are paying your bills on time and on the right terms. This is the biggest factor in a credit score. One late payment can have a significant impact on your score.
This includes how much you owe on loan/credit balances, as well as how much of your available credit you are using. If you are maxing out your credit or using most of it, this will have a negative impact on your score.
Length of Credit History
The longer you have an established credit history, the better your score should be.
This looks into how many times you have applied for new credit. If you have too many credit inquiries, then this will lower your credit score
This is factored on what types of credit you use. A consumer that has both credit cards and loans in good standing will likely have an increase in their score due to this.
Why is a credit score important?
A credit score can have a big impact on your life. It can determine whether you are approved for a loan, the interest you will pay, your ability to obtain a mortgage, and even if you are approved to rent. The higher a credit score, the better. This tells lenders, renters, and employers how you manage your finances.
What is the range for a credit score?
Credit scores range on average from 300–850, depending on the credit bureau. The higher a credit score, the lower risk a consumer will pose for a creditor. The most used method of scoring credit is the FICO score range. Approximately 95% of financial institutions in the U.S. use FICO (FICO, 2016).
What is considered a good and bad credit score?
Different creditors have different criteria for what is good credit score vs. a bad one. The ranges will differ by a couple of points from each credit bureau. Below is an example of FICO range and how the score rates.
As you can see, many things are taken into consideration when it comes to a consumer credit report and score. The interest you receive on credit is more than likely factored by what is on your credit report and your credit score. It’s very important to be well informed when it comes to these two things. Being informed will make it much easier when you:
- Apply for a loan
- Apply for a credit card
- Rent an apartment
- Buy a house
- Better opportunities in credit lines
How can I access my credit report and score?
You can access your credit report for free once a year from each of the major credit bureaus. To access your free credit report, try any of the following methods:
Go to https://www.annualcreditreport.com where you will fill out basic information about yourself to access your credit report.
Call (877) 322-8228 and order a credit report by phone.
Download a request form from https://www.annualcreditreport.com/ and mail to:
- Annual Credit Report Request Service
- P.O. Box 105281
- Atlanta, GA 30348-5281
You do not have to access all your credit reports at once. You can stretch them out during the year. That way, you have access to an updated credit report during the whole year. To access your credit score at any time, you can contact the credit bureaus directly. However, there may be a charge for this.
How can I improve what is in my credit score or report?
In order to improve your credit score, you will have to learn how to manage your credit responsibly. Your credit score will not improve right away. It takes time and planning in order to see change, but it is possible. Here are some ways to improve your credit score:
- Verify all information on your credit report. If any information is missing or wrong, contact your creditor and credit bureau.
- Pay off all debts on time.
- Keep credit accounts open, and do not use all your credit you have available.
- Know your credit score.
- Create a budget and financial plan.
Things to consider when applying for credit or a loan
Always think ahead when applying for credit. Analyze why you need the credit and if you will have difficulty paying off the credit. Research the type of credit you apply for as well and be informed of your rights as a consumer. Make sure the interest and charges are clear as well. Have the creditor go over the APR and any charges that will apply. Apart from charges, it’s important to note how long you will be paying off the credit and if you can pay early with no penalties (Allbusiness 2016).
The first thing you want to look for when you begin financial planning is your debt. Debt is the money you own. Debt and credit differ. Credit is the ability to borrow money, while debt is the aftermath of borrowing. An example is listed below.
A good way of knowing how much debt you have compared to your income is the debt-to-income ratio (DTI). The debt-to-income ratio looks into how much you pay in debt a month compared to your monthly income before deductions (Investopia 2016). The calculation would be:
Total monthly debt ÷ Total income = Debt to income ratio.
The lower the ratio the better. Creditors and lender may use this to see if you qualify for credit/loan. In general, a DTI at or less than 36% would be ideal.
Reducing Debt and Budgeting Your Finances
A great way to reduce your debt is to create a budget that lists and tracks all of your expenses and income. By tracking all your expenses, you can then categorize them all and analyze your finances as a whole.
Another option is creating a budget. This allows you to enter the projected expense amount and the actual for everything you buy. These will help you see what expenses you can cut off or reduce, as well as analyze in order to make changes in your expenses. Below is a sample spending expense sheet and budget that can be used to organize your expenses.
Being conscious of your credit and your finances well benefit you greatly as a consumer. Knowing what is on your credit report and credit score will help you in the future when you apply for credit. By staying informed about your credit, you are taking control of what is on your credit report and knowing how you can improve your credit and finances.
Allbusiness editors (2016) Top 5 things to consider before applying for a loan. Retrieved from here.
Experian (2016) What is credit. Retrieved from
Federal Trade Commission, (2016) Consumer Information: Free Credit Reports. Retrieved from here.
FICO (2016) FICO at a Glance. Retrieved from here.
Greenpath (2016) Credit reports 101. Retrieved from here.
Investopia (2016) Debt-to-Income Ratio- DTI. Retrieved from here.
MyFico (2016) What’s in my credit report? Retrieved from here.
MyFico (2016) What’s in my FICO Scores. Retrieved from here.