Credit is an agreement between a lender and a borrower that allows the borrower to obtain funds, goods or services now and repay them later. Credit can also refer to your history of borrowing and repaying money. Having good credit—a history of repaying loans on time and as agreed—can make it easier to get approved for a range of credit products.
Building credit is a key part of creating a strong financial foundation. Not only does credit impact how easily you can borrow, but it can also come into play when you're obtaining insurance, renting an apartment or even seeking a job. Understanding the basics of credit agreements and credit scores can help you build and manage yours well. Here's what credit is and how it works.
What Is Credit?
"Credit" is a financial term that has a couple different definitions. One definition of credit is the ability to borrow money and repay the balance you owe over time. A credit agreement typically includes interest that a person has to pay in exchange for the ability to borrow.
Another definition of credit is an assessment of an individual's borrowing history. In this context, having good credit means that you have a history of responsibly borrowing and repaying debts. On the other hand, having poor credit may mean that you don't have much established borrowing history or that you have some negative information in your credit history.
Your credit history is recorded in the credit reports maintained by the three national consumer credit bureaus—Experian, TransUnion and Equifax.
What Is a Credit Report?
A credit report is a financial record containing information about an individual's history of borrowing and repaying debts. Your credit report contains data on how you've managed your current and past credit accounts.
Credit scoring companies use the information in your credit report to calculate your credit scores. In addition, creditors and other businesses may request your credit report as part of an application for credit, an apartment, utilities, a job and more.
What Is a Credit Score?
A credit score is a three-digit number derived from data found in one of your credit reports. Lenders look at your credit score as an indicator of how experienced and reliable you are at borrowing and repaying debt.
While individuals typically have many different credit scores, the main credit scoring models are the FICO® Score☉ and the VantageScore® credit score. These two models differ in how they calculate your credit scores based on the information in your report. That said, both are designed to predict the likelihood that a borrower will fall delinquent on payments.
FICO® Scores are used by 90% of top lenders to check the creditworthiness of applicants. The general-use FICO® Score ranges from 300 to 850. Scores that fall closer to 300 represent poorer credit, and those that fall closer to 850 represent good to exceptional credit.
| FICO® Score Ranges | |
|---|---|
| 800 to 850 | Exceptional |
| 740 to 799 | Very good |
| 670 to 739 | Good |
| 580 to 669 | Fair |
| 300 to 579 | Poor |
How Is Your Credit Score Calculated?
Different credit scoring models use their own formulas for calculating your credit score based on the information in your credit report. Here's a breakdown of what affects your FICO® Scores:
- Payment history (35%): The most influential factor in your FICO® Score, payment history is a record of how you've managed your debt payments over time. Making on-time payments builds a positive credit history. On the other hand, late or missed payments, accounts sent to collections, foreclosure and bankruptcy all have a negative impact on your payment history.
- Amounts owed (30%): This second most influential scoring category is based on how much money you owe overall. It factors in your outstanding balances, the total amount of debt listed on your credit report and, importantly, what percentage of your available revolving credit (mainly credit cards) you're using.
- Length of credit history (15%): This credit scoring factor measures how long you've been using credit. It takes into account the average age of all your credit accounts, the age of your oldest account and how long it's been since you last opened an account. Keeping old accounts and only applying for new credit when necessary can help you improve the length of your credit history.
- New credit (10%): This scoring factor takes into account recent hard inquiries on your credit report and how many accounts you've recently opened. Too much new credit in a short period can make you appear risky to lenders. Avoiding applying for credit you don't need can help you improve in this category.
- Credit mix (10%): Credit mix takes into account how varied the types of credit you have are. An ideal credit mix includes both revolving credit and installment credit (more on this below).
Types of Credit
There are all sorts of credit products designed to accomplish different goals, like earning points on a purchase or getting an education. Zooming out, most types of credit can be broadly classified as either installment credit or revolving credit.
Installment Credit
Installment credit is a lump sum of money that you borrow and repay over time. Installment credit agreements come with a set repayment schedule and typically a fixed interest rate.
You agree to the amount of your loan, the period of repayment and the amount of your fixed monthly payments at the onset. Then, you continue to make payments toward your principal balance and interest until the loan is paid off.
Examples of installment credit include:
Revolving Credit
Revolving credit is a type of credit that allows you to borrow up to a set credit limit. You'll typically be required to make minimum payments each month, and carrying (or revolving) a balance will usually result in interest charges.
With revolving credit, you can borrow what you want to, when you want to, up to your credit limit. After you pay down your balance, you're free to borrow up to your credit limit again. If you don't have a balance in a given statement period, you won't be required to make a payment.
Revolving credit products typically come with variable interest rates. That means the amount of interest you'll pay to borrow can fluctuate over time, changing to match benchmark market rates.
Generally speaking, interest rates for variable or revolving credit are higher than what you'll pay for fixed-rate, installment loans. That said, paying off your balance before interest begins to accrue allows you to benefit from the convenience of revolving credit without sacrificing money to interest.
Examples of revolving credit include:
Why Is Credit Important?
Credit is important if you plan to borrow money for major purchases, such as a car or home. Credit can also come into play in other areas of your life too—like when you're trying to lower your insurance premiums or set up utilities.
- Qualifying for new credit: Your credit score has a big impact on which credit cards and loans you'll be able to get approved for. In addition to looking at your credit history to qualify you, lenders may also base the interest rate you'll pay to borrow on your credit score. Broadly speaking, higher credit scores help you access a wider range of credit with better terms.
- Renting a home: Some rental companies and landlords pull your credit as part of your rental application. A low score can disqualify you from some rentals, or require you to put down a larger security deposit or find a cosigner to guarantee your rent.
- Buying a home: As is the case with other loan types, your credit is a qualifying factor when you apply for a mortgage. Focusing on building credit well before you're ready to buy can help you ensure you're eligible to borrow—and help you access lower mortgage rates—when it's time to buy.
- Insurance rates: Some insurers look at your credit-based insurance score when setting your home and auto insurance premiums. Credit-based insurance scores use your credit history to calculate how likely you are to file a claim. Note that some states restrict the use of credit-based insurance scores.
- Utilities: Some utility companies check your credit before agreeing to enroll you in services or lend you equipment. If your credit is low, a utility company may ask you to put down a deposit to receive service.
- Applying for a job: Some employers may review your credit history as part of their background checks during the hiring process. Note that employers can't see your credit score, only a limited version of your credit report. Also, not all states allow the use of credit checks during applicant screening.
How to Build Credit
Think of building credit as a long-term endeavor. It takes time and consistency to build up a long history of managing credit well. Reaching your big credit goals—like qualifying for a mortgage or a credit card with the perks you want most—comes down to practicing good credit habits now.
Here are steps you can take to start building credit.
- Check your credit report. You can check your credit report for free through Experian to see your credit score, plus what information appears on your report. You should also check for any unrecognized credit activity, which can be a sign of fraud. You have the right to dispute information on your credit report, which can result in its removal if it is determined to be inaccurate. The removal of inaccurate information from your report (such as mistakenly reported late payments) could lead to improvements in your score.
- Apply for a credit card or loan. If you're totally new to credit or if your score could use substantial improvement, consider starting with a credit product tailored to improving your score. Secured credit cards and credit-builder personal loans are two options to consider. You could also consider becoming an authorized user on a trusted loved one's credit card to add positive payment history to your credit report.
- Make on-time payments. Payment history is the largest factor in determining your credit score. To ensure you're avoiding late payments, budget the funds you'll need and set up autopay.
- Don't max out your credit cards. Even if you don't miss payments, maxing out your credit cards can have a negative impact on your score. Your credit utilization rate is a measure of how much of your available revolving credit you're using. Aim to keep your utilization rate below 30%. The lower, the better.
- Don't apply for credit too often. While some new credit is necessary for building your credit history, avoid applying for new credit too often. Too many new applications can signal risk to lenders and lead to a temporary dip in your scores. In general, avoid taking out multiple loans or applying for credit cards you don't need.
- Get credit for paying your bills. If you're already making on-time monthly utility, phone, insurance and streaming payments, you could be using them to increase your FICO® Score. Experian Boost®ø is a free feature that scans your banking transactions to give you credit for eligible bill payments. It's easy to sign up, and those with a history of eligible payments could see an instant FICO® Score increase.
Monitor Your Credit
Whether you anticipate needing to borrow soon or just want to establish credit as part of your financial journey, start by getting familiar with your credit. Consider signing up for free credit monitoring with Experian for an ongoing look at your credit progress.
With credit monitoring, you'll also get individualized insight into steps you could take to improve your score, such as paying down a balance or considering a new credit card. Taking steps to build credit now can help you shave percentage points off the rate you may pay to take out a mortgage or finance a car down the road.