How Credit Works: What You Need to Know
- How Credit Works
- The Different Types of Credit
- The Different Types of Credit Cards
- The Different Types of Credit Reports
- How to Build Credit
Credit is an important part of our financial system, but it can be confusing to understand how it works. In this blog post, we’ll explain the basics of credit and how it can impact your finances.
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How Credit Works
Credit is a type of loan that allows you to borrow money up to a certain limit. You can use credit to make purchases or get cash advances. When you make a purchase with credit, you are borrowing money from the credit issuer and will be required to pay it back over time. There are a few things you should know about credit before you get started.
How credit scores are determined
Credit scores are determined by a number of factors, including your payment history, amount of debt, length of credit history, and new credit inquiries.
Your payment history is the most important factor in your credit score. It’s important to pay all your bills on time, every time. If you have missed payments in the past, you can try to improve your score by catching up on those payments and making sure you don’t miss any more.
The second most important factor is the amount of debt you have. Having a lot of debt doesn’t necessarily mean you’re a bad candidate for a loan, but it does mean you’re a higher risk than someone with no debt. Lenders will be more likely to approve a loan for someone with little or no debt than for someone who is carrying a lot of debt.
The third factor is the length of your credit history. The longer you’ve been using credit, the better your score will be. This is because lenders like to see a history of responsible credit use before they approve a loan.
The fourth factor is new credit inquiries. Whenever you apply for new credit, lenders will pull your credit report to see if you’re a good candidate for the loan. This process is called an inquiry, and each one can slightly lower your score. So it’s best to only apply for new credit when you really need it.
What factors influence credit scores
There are a number of factors that can influence your credit score, including your payment history, credit utilization, credit mix, and length of credit history.
Your payment history is the most important factor in your credit score. It accounts for 35% of your score. This means that if you have a long history of timely payments, it will have a positive impact on your score. On the other hand, if you have a history of late or missed payments, it will have a negative impact on your score.
Credit utilization is the second most important factor in your credit score. It accounts for 30% of your score. Credit utilization is simply the ratio of your outstanding balances to your total credit limit. For example, if you have $500 in outstanding balances and a $1,000 credit limit, your credit utilization would be 50%. Generally speaking, you want to keep your credit utilization below 30%. This shows lenders that you’re using a manageable amount of your available credit and that you’re unlikely to get into financial difficulty.
Credit mix is the third most important factor in your credit score. It accounts for 15% of your score. Credit mix refers to the different types of debt that you have on your credit report. For example, revolving debt (such as credit cards) and installment debt (such as auto loans) are two different types of debt. Lenders like to see a mix of both because it shows that you can handle different types of debt responsibly.
Length of credit history is the fourth most important factor in your credit score. It accounts for 10% of your score. Length of credit history simply refers to the amount of time that you’ve been usingcredit — the longer you’ve been using it responsibly, the better it will be for your scores because it shows lenders that you’re a reliable borrower .
The Different Types of Credit
There are many different types of credit, each with their own benefits and drawbacks. The most common type of credit is a line of credit, which can be used for anything from home repairs to making a large purchase. A line of credit is a great way to get the money you need when you need it, but it can also be a great way to get into debt if you’re not careful. Another type of credit is a credit card, which can be used for anything from everyday purchases to emergencies. A credit card can be a great way to build your credit, but it can also be a great way to get into debt if you’re not careful.
An installment loan is a loan in which there are a set number of scheduled payments over time. The term of the loan can vary from a few months to several years. A mortgage, for example, is a type of installment loan. The borrower receives a lump sum at the beginning of the loan and then makes equal monthly payments until the loan is paid in full.
Other types of installment loans include auto loans, student loans and personal loans. With an auto loan, the borrower receives a lump sum at the beginning of the loan to purchase a car, and then makes equal monthly payments until the loan is paid in full. Student loans are similar, but the lump sum is used to pay for tuition and other school-related expenses. Personal loans can be used for anything from home improvements to consolidating debt.
Revolving credit is a type of credit that allows you to borrow money up to a certain limit. You can borrow and repay the money as many times as you want, as long as you don’t exceed your limit. Credit cards are the most common type of revolving credit. Other types of revolving credit include home equity lines of credit (HELOCs) and some types of business loans.
With revolving credit, you’ll typically be charged interest on the money you borrow. The interest rate will be based on your credit score and the prime rate. If you have a good credit score, you’ll likely qualify for a lower interest rate. If you make your payments on time and keep your balance low, you can save money on interest over time.
If you’re considering using revolving credit, it’s important to understand how it works and what the potential risks are. Revolving credit can be a helpful tool if used responsibly, but it can also lead to debt problems if you’re not careful.
Secured loans are those in which the borrower offers collateral — usually in the form of some type of asset such as a house, a car, savings account, certificates of deposit, or even stock shares — to the lender. The value of the collateral is typically equal to or greater than the amount of money being borrowed. In the event that the borrower defaults on the loan (fails to make payments), the lender has the right to seize and sell the collateral to repay the loan. Because secured loans involve less risk for lenders, they usually come with lower interest rates than unsecured loans.
There are two main types of secured loans: home equity loans and auto loans.
Home equity loans are typically used for home improvements, debt consolidation, or other major expenses. The borrower uses the equity in his or her home — that is, the portion of the home’s value that is not currently mortgaged — as collateral. Because home equity loans are secured by your home, they usually come with lower interest rates than unsecured loans. However, if you default on a home equity loan and your home goes into foreclosure, you could lose your home.
Auto loans are another type of secured loan. When you take out an auto loan, you use your car as collateral for the loan. If you default on your auto loan payments and your car is repossessed by the lender, you will no longer have transportation (and will probably have a pretty bad mark on your credit report). However, because auto loans are secured by your car, they usually come with lower interest rates than unsecured loans.
Most unsecured loans are installment loans, meaning they come with a fixed rate and a set monthly payment. Mortgage and auto loans are examples of installment loans. With an unsecured loan, there’s no need to put up collateral, such as a house or car, to get the loan.
However, because there’s no collateral backing up the loan, unsecured loans tend to come with higher interest rates than secured loans. Lenders perceive more risk when approving an unsecured loan, so they often charge a higher rate to offset that risk.
For some types of unsecured loans, such as personal loans and student loans, you may be able to qualify for a lower interest rate if you have good credit.
The Different Types of Credit Cards
There are many different types of credit cards available to consumers, and each type has its own set of benefits and drawbacks. Some of the most popular types of credit cards include cash back cards, rewards cards, and balance transfer cards. Let’s take a closer look at each of these types of cards to see how they work.
Standard credit cards
Standard credit cards are the most common type of credit card. They usually have logos from Visa, Mastercard, Discover, or American Express. These cards can be used anywhere that accepts credit cards from those companies. Most standard credit cards have a minimum spending limit of $500 and a maximum limit of $10,000. Standard credit cards usually have an annual fee of $0-$95 and a grace period of 21-25 days.
Secured credit cards are another type of common credit card. They are similar to standard credit cards but require a security deposit to open the account. The deposit is usually equal to the credit limit on the card (for example, if you have a $500 credit limit, you would need to make a $500 deposit). Secured credit cards are often used by people who are trying to build or improve their credit scores.
Prepaid debit cards are another type of common credit card. They are not technically considered credit cards because you cannot borrow money with them. Prepaid debit cards work like debit cards or checks—you load money onto the card and then use it to make purchases or withdrawals until the balance is gone. Prepaid debit cards sometimes have fees associated with them, so be sure to read the fine print before you sign up for one.
Rewards credit cards
A rewards credit card is a card that offers you points, miles or cash back for every dollar you spend.
The types of rewards offered by credit cards can vary widely. Some cards give you points that can be redeemed for travel, while others give you cash back that you can use for anything.
Rewards credit cards usually come with annual fees and higher interest rates than other types of credit cards, so it’s important to choose a card that offers rewards that are valuable to you and that you will be able to use.
Here are some things to consider when choosing a rewards credit card:
-What type of rewards does the card offer?
-How easy is it to redeem the rewards?
-Does the card have an annual fee?
-What is the interest rate on the card?
Secured credit cards
A secured credit card is a credit card that requires you to put down a deposit in order to open the account and access your credit limit. The deposit you make serves as collateral for the account, which means that if you default on your payments, the credit card issuer can take your deposit in order to cover the outstanding balance. For this reason, secured credit cards tend to be easier to get approved for than unsecured cards, making them a good option for people with bad or limited credit histories.
Most secured cards work like any other credit card, which means you can use them to make purchases and build up your credit history by making on-time payments. However, some secured cards come with additional features and benefits that can help you improve your financial situation. For example, some secured cards offer rewards programs that give you cash back or points for every purchase you make. Others may waive certain fees, such as annual fees or foreign transaction fees, or offer a lower APR (annual percentage rate) than unsecured cards.
If you’re looking for a secured credit card, be sure to compare different offers to find one that best suits your needs.
The Different Types of Credit Reports
Most people know they have a credit score, but few understand how credit scores are calculated or what goes into them. A credit score is a number that lenders use to decided whether to give you a loan and what interest rate to charge.
Annual credit reports
Annual credit reports are free reports that you’re entitled to by law. You can get your report from each of the three credit reporting agencies (Equifax, Experian and TransUnion) once every 12 months. The best way to get your report is to go to www.annualcreditreport.com, a website set up by the credit agencies specifically for this purpose. You can also order your report by phone or mail if you prefer.
When you request your report, you’ll need to provide some basic information about yourself, including your name, address, Social Security number and date of birth. You’ll also need to specify which credit bureau’s report you want to receive. Once you have your report in hand, take some time to review it carefully. Check for any errors or incorrect information, and if you find anything that looks suspect, contact the credit bureau directly to have it corrected.
Credit monitoring services
Credit monitoring services are a great way to keep track of your credit report and score. These services will send you alerts if there are any changes to your report or score, which can help you catch identity theft early. They can also help you keep track of your credit utilization, which is a major factor in your credit score.
How to Build Credit
If you want to buy a house or a car, or even get a credit card, you need to know how credit works. A good credit score can save you thousands of dollars in interest over the life of a loan, and it can also help you get approved for loans and credit cards with better terms. But what is a credit score, and how do you get one?
Use credit wisely
You’ve probably heard the term “credit score.” But what is a credit score, and why is it important? A credit score is a number that lenders use to determine how likely it is that you will repay a loan. The higher your credit score, the more likely you are to be approved for a loan and to get better loan terms — which can save you money. A good credit score can also help you qualify for lower insurance premiums.
You can get a free copy of your credit report from each of the three major credit bureaus — Equifax, Experian, and TransUnion — once every 12 months at AnnualCreditReport.com. (You can also get your free report if you’ve been denied credit, employment, or insurance in the past 60 days.)
Most people have what’s called a “FICO score” named for the company that created the scoring system. FICO scores range from 300 to 850; the higher your score, the better. You have four different FICO scores, one from each of the three major credit bureaus and one “generic” FICO score that’s an average of all three.
There are other scoring models besides FICO scores, but they aren’t as widely used by lenders. One reason is that these other scoring models aren’t always consistent — a good score on one might not be a good score on another. So if you have a high score on one system and apply for a loan using another system, there’s no guarantee that your application will be approved.
Whatever scoring model a lender uses, there are five key things that affect your score:
-Payment history: Do you pay your bills on time? Late and missed payments will hurt your score.
-Amounts owed: This includes how much debt you have in comparison to how much credit you have available — called your “credit utilization ratio.” It also looks at individual debts, such as whether you owe more than $50 on any one credit card or other loan. The more debt you have relative to your available credit, the lower your score will be. -Credit history: This looks at how long you have had lines of credit — like credit cards and loans — open and active in your name. In general, the longer your history, the higher your score will be (assuming everything else is equal). But even if you don’t have much of a history yet because you just turned 18 or moved to the U.S., don’t worry! You can still build good credit by using credit wisely and making sure to keep up with payments over time. -Credit mix: This looks at different types of debt in order to assess how well-rounded of a borrower you are; having both installment loans (like car loans) and revolving debt (like credit cards) shows lenders that you manage different types of debt responsibly.-New inquiries: When lenders see new inquiries on your report, they may think that you are trying to acquire too much new debt too quickly — which could indicate financial instability or irresponsible borrowing behavior.-Your FICO® Score may also be affected by things like public records (bankruptcies, tax liens), collection accounts and certain demographic information (like your age).
Establish a good payment history
One of the most important things you can do to establish good credit is to make your payments on time, every time. Payment history makes up 35% of your FICO® Score, so late or missing payments can have a big impact on your score.
You can set up automatic payments for your bills through your bank or credit card issuer to make sure you never miss a payment. You can also sign up for text or email alerts from your lender to remind you when a payment is due.
In addition to making timely payments, avoid maxing out your credit cards. Using more than 30% of your available credit line on any one card hurts your credit scores, even if you pay the balance in full each month.
Use a mix of different types of credit
When you use credit, it’s important to mix up the types of credit accounts you have. That’s because one type of account might send a different message to creditors than another type.
Here are some examples of different types of credit:
-Installment loans. These are loans that you pay back in fixed monthly payments, such as auto loans and mortgages.
-Revolving debt. This is debt that you can carry from month to month, such as credit cards.
-Secured loans. These are loans that require collateral, such as a savings account or CD that the lender can seize if you don’t repay the loan.
Using a mix of these types of credit shows creditors that you’re responsible with different kinds of credit products. That can boost your score more than if you only have one type of account.