Cracking the Credit Code: An Explainer on How Credit Works

Credit is an integral part of the American financial system, shaping our ability to make significant purchases and access financial opportunities. Understanding how credit works in the United States is crucial for managing your finances effectively and making informed decisions about loans, credit cards, and more. In this comprehensive guide, we will demystify credit and explain its workings in the United States.

What is credit?

Credit is a financial arrangement that allows individuals and businesses to borrow money or access goods and services with the promise to repay the borrowed amount, often with interest, at a later date. It is a system built on trust, where lenders extend credit to borrowers based on their creditworthiness.

The Role of Credit Reports

In the U.S., credit information is primarily collected, stored, and managed by three major credit bureaus: Equifax, Experian, and TransUnion. These bureaus compile data on individuals' credit histories, including credit card accounts, loans, payment history, and public records such as bankruptcies or tax liens.

These reports are used by lenders to evaluate your risk of potentially not paying back borrowed money. So the higher the credit score is, the less likely you’re viewed as a risk to banks.

Factors That Affect Your Credit Score

There are several factors that can positively or negatively affect your credit score.

Payment History (35% of your score): The most significant factor is your payment history, which includes on-time payments, late payments, and any missed payments.

Amount Owed (30% of your score): It isn’t bad for you to use the credit you’re given. However, if you’re using too much of it, credit bureaus can look at this as a sign that you’re struggling to pay your bills.

Length of Credit History (15% of your score): The length of time you've had credit accounts can positively impact your score. So if you’re regularly applying for new credit cards, it can bring down the average age of your credit.

New Credit (10% of your score): Opening multiple new credit accounts in a short period can temporarily lower your score.

Types of Credit (10% of your score): A diverse mix of credit accounts, such as credit cards, installment loans, and mortgages, can positively affect your score.

Types of Credit

There are various forms of credit available in the United States, and each one can impact your credit score differently:

Revolving Credit: This includes credit cards and lines of credit, where borrowers can continuously borrow up to a specific limit and make regular payments.

Installment Credit: This type involves borrowing a specific amount and repaying it in fixed, scheduled payments, such as auto loans or mortgages.

Secured Credit: Secured credit requires collateral, such as a deposit for a secured credit card or the financed item itself, as with auto loans.

Unsecured Credit: Unsecured credit does not require collateral, as with most credit cards and personal loans.

How to establish credit

For those new to credit or seeking to rebuild their credit, establishing a positive credit history is essential:

Secured Credit Cards: Secured credit cards are an excellent way to build or rebuild credit. They require a deposit, which becomes your credit limit.

Become an Authorized User: Being added as an authorized user on someone else's credit card account can help you piggyback on their positive credit history.

Retail Store Cards: Store credit cards are often more accessible to those with limited or poor credit histories. However, they typically have higher interest rates.

Using Credit Wisely

Using credit on a regular basis isn’t necessarily a bad thing as long as you use it responsibly. Here are ways to manage credit given to you by a lender:

Pay Bills on Time: Timely payments are the foundation of a good credit score.

Monitor Your Credit Score: Regularly check your credit reports for errors and discrepancies. You can access one free credit report from each bureau annually through AnnualCreditReport.com.

Manage Your Credit Utilization: Aim to keep your credit utilization below 30% of your credit limit on each account.

Avoid Accumulating Debt: Don't take on more credit than you can manage. Avoid maxing out credit cards or taking on excessive loans.

Keep Older Accounts Open: The length of your credit history matters, so keep your older accounts open, even if you don't use them frequently.

The Impact of Credit on Financial Opportunities

Having good to excellent credit opens a plethora of financial opportunities for you. Without it, you can be potentially left with few, less desirable options.

Here’s what you could potentially get if you optimize your credit score.

Lower Interest Rates: Interest rates on loans are determined partially by how much risk you may be to a lender that you won’t pay your loan off. The higher your credit score is, you can potentially earn lower interest rates on mortgages, auto loans, and personal loans.

Better Housing Opportunities: Landlords often check credit reports, so good credit can make it easier to secure rental properties.

Improved Employment Options: In certain industries, employers may check credit as part of the hiring process, impacting job prospects. And with a lower credit score, you could potentially appear as less desirable for employment.

Bottom line

Credit is a fundamental aspect of personal finance in the United States, influencing everything from loan approvals to job prospects. By understanding how credit works and practicing responsible credit management, individuals can build and maintain good credit, opening doors to a world of financial opportunities and paving the way to a more secure and prosperous future. Stay informed, monitor your credit, and make wise financial choices to leverage the power of credit in your financial journey.