Good credit often feels elusive.
You may know it’s the key to leasing a car, starting a business, or buying your first home. Or, a way to unlock the most affordable interest rates. But the path to achieving those numbers isn’t exactly clear.
So, how does credit work? We are here to pull back the curtain.
Getting to Know Credit Basics
Before talking about how to establish good credit scores—yes, you have more than one!—let’s go over some credit basics.
Credit is a powerful tool. It gives you the opportunity to borrow money to buy things.
Your credit history and scores impact which products are available to you—and how much you will have to pay in interest. Your scores may also affect how much time you have to pay back the money.
No one is born with credit scores. You have to establish your own credit history.
Some folks start with a secured credit card—which requires a starting deposit—or, they may apply for a low limit student credit card. Alternatively, they may become an authorized user on someone else’s account.
Either way, it’s always better to start building credit as early as you can.
You will be grateful when the time comes to actually apply for a car loan or your first utility bill. Some of the most common types of credit include:
- Installment loans – mortgage, personal loans, car loans
- Revolving credit – credit cards, home equity line of credit (HELOC)
- Service credit – utilities, memberships, subscriptions
What are Good Credit Scores?
When you are familiar with the types of credit, you may be left wondering, “how does credit work?”
Your credit scores begin with three reporting agencies—Experian, Equifax, and TransUnion.
These agencies keep track of your credit history. Each credit report will include your credit balances, types of accounts, and payment history. You may also see negative marks like late payments or debt in collections.
Two companies—FICO and VantageScore—use the data from these reports to calculate your credit scores. Most lenders and creditors use either FICO or VantageScore to make decisions. Both company’s score ranges are 300 to 850.
A good credit score is usually 670 or higher for FICO and 661 or higher for VantageScore.
The higher your credit scores, the more attractive borrowing options you may have.
How to Improve Your Credit Scores
Now that you understand the credit basics, you may be eager to start making improvements. First, let’s take a closer look at what actually impacts your scores.
- Your history of on-time payments (35%) – The single most important factor for your credit scores is your payment history. It’s important for lenders or creditors to see you will pay them back on time.
- How much credit you are using (30%) – This compares your total available credit with how much you are currently using. Your credit card utilization percentage is especially important.
- Total length of your credit history (15%) – This includes how long each of your credit accounts have been open.
- Different types of credit (10%) – This is your mix of different types of credit—credit cards, mortgage, personal loans, and more.
- Applying for new credit (10%) – If you have recently applied for a bunch of new accounts, it could be a red flag to lenders or creditors.
As you can see, five factors impact your scores and they each carry different levels of importance.
Focus on these activities to make the biggest impact on your scores:
- Check all three credit reports for errors.
- Always make on-time payments with all of your accounts.
- Keep your total credit utilization below 20%.
- Don’t close your older credit cards.
How does credit work?
In a perfect world, you could afford to pay cash for everything—medical bills, vehicles, new businesses, or even a home.
But that’s not the reality for most people. To pay for these things, you may need to borrow money, which is why it’s important to know credit basics.
It takes a little work, but the sooner you improve your scores, the more options you will have at your fingertips.