What is Credit and How Does it Work?

It is inevitable that at some point in your life you will need to rely on credit. Whether you’re trying to rent an apartment, buying a house, or making the leap and finally getting that sweet ride you’ve always dreamed of. Your credit score can make or break your purchasing power. Let’s take a look at how you can become the master of your credit.

What is Credit?

Credit is an agreement between you and a financial intuition in which they loan you money which you agree to pay back at a later date, usually with interest (extra money) … and not the good kind of interest. Your credit score is the basis in which these financial institutions determine how responsible you are with credit and the likelihood you will pay back the money you borrow. I mean, would you want to loan great uncle Frank thousands of your hard-earned dollars with a pinky promise that he will repay you? My guess would be no. The basic gist, the better your credit score, the more likely the banks are to trust you with the money they loan you.

Why Do I Need Credit?

Credit can help you get the things you need when you need them. A house, a car, a Rolex (please don’t use credit to increase frivolous spending) can all be acquired using credit. In general, the better your credit score = the better your interest rate and credit limit will be.

Your credit score reflects your financial behavior and is determined by a combination of factors like do you pay your bills on time, the amount you currently have in unpaid debt, the amount of time you have been building your credit and what types of credit you utilize (mortgage, car loans, credit cards etc.)

So, What Should My Credit Score Be?

The most commonly used credit score range is 300 - 850. FICO is the most widely used scoring system and determines your credit score based on the following ranges.

Courtesy of Nerdwallet.com

800-850 = Exceptional

740-799 = Very Good

670- 739 = Good

580-669 = Fair

300-579 = Poor

How Do I Find My Credit Score?

You are entitled to a free copy of your credit score every 12 months from each of the three credit reporting agencies. Equifax, Experian and TransUnion are the three agencies that will provide your annual report. There are a lot of credit reporting sites you can go to in order to access your credit report. Just be careful to read the fine print and make sure you are not agreeing to use a company that charges fees. Annualcreditreport.com is the most reliable source for getting your report from all three agencies.

What If I Don’t Like My Credit Score?

If you receive your credit report and are surprised by the number, like not in a good way surprised. Don’t panic. It can be fixed. First, make sure to check your report for errors, and not I forgot I opened a Victoria Secret, Target and Kohl’s charge card kind of errors. I mean errors with your identity information (wrong name, address, phone number), same debt listed more than once, closed accounts that are reported as open, or accounts with balance errors. Your credit report will have information on who to contact to dispute inaccurate information.

Paying your bills on time will have a tremendous impact on improving your score. Your payment history accounts for 35% of your total credit score! If you are forgetful about getting your payments in on time, set up auto pay for recurring bills like your mortgage, car loans and student loans. Just be sure you have enough money in your account to cover these payments or you could be charged an overdraft fee. Contact the company that controls your loan and have them automatically deduct payments from your account, so you don’t have to worry about late payments. Set it and forget it!

Pay down debt. Next to your payment history, your amount of debt owed makes up 30% of your FICO score. Making a habit of paying off your credit card bills at the end of every month will help build your credit and ensure you don’t have to pay any interest fees. I don’t know about you but, having to pay an interest fee because I forgot to pay a bill makes me irritated with myself and admittedly say bad words.

Avoid acquiring new debt. Every time you apply for a loan of any type, lenders will run what’s called a hard inquiry. This credit check will lower your score between 1-5 points. If you have numerous hard inquiries in a short period of time, lenders may consider you a risk since you are trying to borrow from multiple sources. Applications for new credit make up 10% of your FICO score.

To Sum It Up

Look, credit can be a tricky thing. If you consider yourself financially responsible, credit can open the door to many wealth building opportunities. On the other hand, if finances have never really been your thing, credit can get you into a world of trouble.

Put it this way, let’s say you want to apply for a 200,000 mortgage with a fixed rate for thirty years. If your credit score is in the excellent range, the lender may charge you a 3% interest rate which would make your monthly payments $843. Now let’s say you apply for the same loan, but your credit score is in the lower range, say the fair to good range. The lender would consider you more of a risk and might charge you an interest rate of 4.5%. This would make your monthly payments $1,013. That’s a difference of $170 a month. Maybe it’s just me, but an extra $170 a month into my retirement account with an average 8% return… uh, peace out school system!

The point is, the better your credit score, the more money in your pocket. Everyday smart financial moves can add up over time to huge financial gains.