Your Guide to Understanding Credit: Credit 411
In modern terms, your credit can be expressed several different ways and referenced for a wide variety of purposes – some of which are well outside the range of what your fiscal reliability actually proves about you. At its most basic, though, credit is about how good of a risk you are for a lender. How much trouble will you be if they loan you $1,000? $10,000? $100,000? Since you’re not neighbors or relatives with them (most of the time), they’ll need some way to measure that risk in advance.
Your Guide to Understanding Credit
Definition of "Credit"
The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.
There are other ways to use the word, of course, but this is the one we’re going with at the moment. If our goal is understanding credit, it’s by far the most useful. Please notice several things about this definition...
It’s about your ability as a customer to obtain something. Credit is something you accomplish; it’s neither granted to you nor inflicted upon you.
Credit is empowering; it gives you more choices.
Credit involves trust between two parties who usually don’t know each other.
Most folks who extend you credit intend for that money to be repaid. Otherwise you’re using the wrong word for “gift.”
Why Would Someone Extend Me Credit?
I’d like to say we all work at what we love, and the primary drive of any lender is your personal fulfillment and the joy they receive at seeing you happy. Add some puppies and rainbows and little kids playing in the yard and you’ve got a perfectly effective laundry detergent commercial.
While many lenders no doubt take understandable pride in what they do – they make big things possible for normal people, after all – we might as well acknowledge the realities of a capitalist system. Understanding credit means recognizing that lenders extend you credit in hopes of making a profit. That’s why all businesses do what they do. It’s why the vast majority of us go to work in the morning: to get paid.
It’s not selfish or evil. Many perfectly noble, caring, wonderful people have to pay the rent and keep the lights on just like the rest of us. Police officers get paid. Firemen get paid. Doctors and ministers and public school teachers all assume a paycheck is coming at some point. The laborer is worthy of his wages and all that.
If lenders don’t lend anyone money – if they don’t take those risks – lenders don’t make a profit. The more they lend you, the more they can potentially make in return. Obvious enough, right?
The reality is slightly more complicated than that, of course. Lenders try to figure out in advance how likely you are to be late on a few payments, or to default altogether. When that happens, they lose money. Even if they turn you over to their collections department or take you to court, they’re suddenly not making nearly as much as they would be if you simply made your payments. Sometimes they recoup less than they loaned you to begin with. All of this means if they think you might pay them reliably, but can’t be sure based on your past credit history, they’ll need to charge you a higher interest rate to offset that risk.
Why not charge higher interest across the board? Because this is American capitalism and it’s the 21st century. If you’re not happy with the rate offered to you by Bob’s Lending Frenzy, you can walk across the street to Larry’s House of Loans or log in to MunnyBunny.com. Competition lowers prices and improves quality, at least when it’s working as it should, and in the lending business it seems to be working. Understanding credit works both ways – the system works for you as much as it works for them.
So credit is about measured risk. The more they loan out, the more they can potentially earn. The higher the risk, however, the greater the chance they’ll lose some or all of what they’re loaning.
What Does This Mean For Me?
From your end this means that the better your credit, the easier it will be for you to borrow money when you need it. The better your credit, the better interest rates you’ll be able to secure when you buy a home, finance a truck, open a credit card, or take out a loan to pay for your daughter’s wedding.
As we already mentioned a credit card, we have some offers for you. We bring you some credit card options to look into. Enter the necessary information and you may get a suggestion you like:
You may not need a loan today. That’s great. You may not plan on buying anything big this year. That’s wonderful. Here’s to being happy with what we have. But at some point chances are good you’re going to wish you had access to some cash, fairly promptly, and on reasonable terms. I don’t know if you’ve noticed or not, but life doesn’t always play fair and weird stuff happens without warning, even to the nicest people.
Which, I assume, is you. At least, you seem nice from over here. You should maybe do something different with your hair, but that’s neither here nor there at the moment.
In related news, your credit is often referenced to determine all sorts of things you wouldn’t necessarily associate with borrowing money. If you have insurance – especially on your home – the rate you pay and the type of coverage for which you qualify is often shaped by your credit rating. No joke. Potential employers often run credit reports on people who make it to their shortlist, presumably assuming it tells them something about your reliability and responsibility as an employee. Which cell phone plans you qualify for is largely shaped by – you guessed it – your credit rating.
I’m not justifying these uses – just letting you know they happen. You may end up understanding credit better than some of the folks who make pretty big decisions based on it.
Credit matters. You can like it, or not – but it’s a thing.
What Role Does My Credit Score Play?
Here’s where it can get a bit tricky.
On the one hand, your credit score is intended to be a simplification. It’s a boiled-down, easy-to-read 3-digit number based on your past behavior which essentially ranks how likely you are to make your payments on time and in full. Lenders like it because it gives them something numerical and hard to mess up; even the new kid they hired because someone knew his uncle in the war can look at a 3-digit number, see which boxes it corresponds to on a chart, and respond accordingly.
On the other, simplification doesn’t always work in your favor. Your credit score doesn’t know whether you had a rough few years because you lost your job unexpectedly and a loved one was ill or whether you were just, you know… reckless and stupid. Your credit score doesn’t know what your abilities are, your dreams, your skillset, or your dedication to whatever it is you’re doing right now.
In practice, your credit score largely determines whether or not a given lender will extend you credit. If they will, it largely determines the terms they’re willing to offer. Some lenders give individual agents leeway in making the final decision, based on their impression of you from talking, messaging, or whatever other forms of communication you’re utilizing. These lenders operate under a model that assumes that while understanding credit is essential for their agents, so is understanding people. (It probably wouldn’t hurt to keep that in mind whenever you’re applying for credit; you never know when a little courtesy and preparation might make the difference between an approval or ‘maybe next time.’)
Others, of course, just look at your credit score and go with whatever “box” that puts you in according to their internal rubrics. Such is lending life. There are all sorts of other interesting credit score statistics we’ve discussed previously if you’re interested.
Your credit score also impacts what interest rates you’ll pay. Interest rates aren’t just for bragging rights. For a major purchase like a home, vehicle, or wedding, a half-a-percentage point can mean thousands of dollars saved or spent over the life of the loan. If you have weak or poor credit, you may have to settle for a few high-interest loans as part of getting yourself reestablished, but we don’t want to get comfortable with such terms.
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Personal confession: I still have the first credit card I was offered after my complete crash’n’burn over a decade ago. It took me years of sacrifice and a rather irritating little man (for whom I am eternally grateful) at the local credit counseling office to help me dig out of over $10,000 of completely irresponsible debt. I’ve since managed to qualify for a few alternate cards at much lower rates, but these folks took a chance on me and I suppose I’m nostalgic, silly as that probably is.
I mean, I don’t use it very much – the interest rate is insane. But it’s active and in my wallet and carries a small balance because I’m weird like that.
So… How Important IS My Credit Score?
Sorry, I got a bit distracted telling that story. Your score matters. It’s not everything, but it matters.
Business Insider put it this way:
With a healthy score, not only can you nab a great interest rate, but your lender may throw in better terms for having impeccable credit—all of which could save you some serious cash.
But the perks that can result from an excellent score—generally above 750—don’t stop at interest rates and loan terms. Your digits could potentially have an effect on everything from your career to your love life.
They backed this up with a nifty infographic you should check out. Some if it’s a stretch, but it’s still both informative and amusing.
What Determines My Credit Score?
Another question which should be easier to answer than it is.
See, you don’t just have one credit score. The two most popular forms of credit score are the FICO and the VantageScore. They’re similar, but computed slightly differently. And, for both main score types, we know the general percentages used to compute your score, but not the methods or the details.
For example, 35% (just over a THIRD) of your FICO score is determined by your payment history. Do you pay your bills on time? For VantageScore it’s 40%, the highest single consideration used to compute your score.
We know the percentages, but we don’t know what that means in practical terms. How much does your score drop if one of your credit card providers reports you’re 30+ past due? Is that the same or different as if the electric company reports you as delinquent? We’re pretty sure things like your mortgage payment matter more than, say, your medical debt, but we don’t know this for aact. We just know that a big percentage of your credit score is determined by whether or not you pay your bills on time.
Maybe the details aren’t that important. I mean, I think we’d all agree it’s best to pay our bills on time anyway, whatever the computation, right? And both FICO and VantageScore (a creation of the big three credit reporting agencies – Equifax, Experian, and TransUnion) have every right to their proprietary algorithms or whatever they call them in-house. This isn’t something mandated by federal law or anything – it’s a convenience created by the credit industry to be used by the credit industry.
Those two scores aren’t the only sorts you might see. Auto dealers have their own modifications to determine what sort of financing to offer you, as do some mortgage lenders or other industries. Those free online scores might be FICO or they might be VantageScore, but unless they specify, you don’t really know. It’s easy to get quite lost in credit score basics, should you choose to go down that path.
But here’s the good news – unless you’re trying to enter some sort of “Mr./Mrs. Credit Score” competition, the details aren’t that important. Improving all credit scores works pretty much the same way. Understanding credit is about knowing how to make the system work for you. It’s more important that you get that bill consolidation loan than that you be able to pass a quiz on what makes a 634 different from a 635.
How Do I Improve My Credit Score(s)?
The first thing is to find out what your credit scores actually are. A good place to start is to get your scores from each of the three major credit reporting bureaus.
Keep in mind these aren’t evaluations of you as a person. They don’t know you or most of the important stuff about you. They’re just computations reflecting past financial behavior and attempting to predict future behavior. A higher score than you expect doesn’t mean you don’t have room to grow; a lower score than you’d hoped doesn’t mean you suck.
Grab a drink, take a seat, run the free report, and tell yourself you’re ready.
“Ready for what?” you may ask yourself.
“Ready to meet my scores!” you reply confidently.
Don’t worry, I’ll wait.
If you want to see how you compare to Americans at large, check out the stats we shared when we talked about credit score basics not long ago. Hopefully you’re looking at something above 600 or so? If not, that’s OK – we’ll get you there. If you’re close to 700 or above, you’re in great shape! Keep doing what you’re doing.
Here are the most powerful ways to quickly raise your credit scores:
- Pay Your Bills on Time
I know, I know – we covered this above. But it’s worth repeating. There’s simply no substitute for timely payment.
- Don’t Max Out Your Credit Cards
It’s better to have 2 or 3 cards with, say, a $2,000 limit and a $500 balance on each, than one card with a $2,000 limit and a $1,500 balance. Even though the total balance is the same in both scenarios, part of your credit score is determined by how much available credit you’re not currently using.
- Don’t Close Accounts
This is somewhat counterintuitive, and you won’t get an argument from me if you think it’s best to close out that high-interest card or cancel that tempting department store line of credit. But part of your credit score is computed based on what percentage of your available credit you’re currently using (as we just said above). This is the flip side of that.
- Don’t Apply for Unnecessary Loans
This doesn’t mean you should be afraid to use your credit in normal ways. You want to finance a car, then finance it. Pay off some bills to lower your monthly payment and overall interest rates? Great idea. But don’t borrow unnecessarily, or apply for multiple loans if you only need one.
A small snack is helpful, too. You will be sitting here for a while, so you want to be prepared. - Check Your Credit Report for Errors
It’s a complicated world, and stuff happens. There’s always a chance something has ended up attached to your credit report that shouldn’t be. Fixing it is a great way to improve your credit score, and honestly something you should want to do anyway.
How Important Is My Credit Report?
It varies from lender to lender, but it's a pretty big deal any time understanding credit is involved. Your credit report is different from your credit score in that it contains far more detail on your financial life, now and for many years past.
Your credit report, like your credit score, will vary depending on who runs it. However connected and automated parts of our world have become, credit reporting largely comes down to whether or not Lender A chooses to notify Credit Reporting Agency B when you’re past due. Not all lenders report to all agencies, so while some information will be on all three versions of your credit report, other items may only show up on one or two of them.
And of course, there’s always the possibility of error. Someone way down the food chain enters a Social Security number incorrectly or misreads a report, and boom – you’re reported to one agency as having done this and that while the others show nothing. Those sorts of things are fixable, but they’re no fun.
Here are the things you can generally expect it to include no matter who’s doing the work, however:
Your name, including any variations you’ve used over the years. The most obvious name changes occur during marriage or divorce, but people change what name they’re using for a variety of other legitimate reasons as well. If you’ve sometimes gone by Lawrence, other times by Larry, and at least one creditor insisted on filing you as “Lars,” those are all on your report as well.
Every address you’ve ever had will probably turn up, sometimes along with places you’ve never actually lived but which are associated with you – your spouse’s parents is a popular one or addresses your own parents had before you came along. Phone numbers, too, tend to make for quite a list. It can be fun, trying to go through them and figure out who had what number when. Most of the time this extra info isn’t an issue one way or the other.
You may have many names and multiple addresses, but hopefully, you only have one Social Security Number. That should be the thing that ties everything else together.
This won’t necessarily show how much you made at every place you’ve worked, but almost anyone who’s ever submitted tax paperwork on your behalf (which is every legit employer) will show up. It’s quite a trip down memory lane, I assure you.
The heart of the report, of course, is your payment history. How many times have you been reported as 30+ past due on something? 60+? Longer? Was it once or twice years and years ago, or does it seem to be a regular issue every so often? What sorts of things do you seem to have trouble keeping up with? If you’ve always made your home, car, and credit card payments, but have some disputed medical bills from years ago, they may certainly show up. They matter, of course, but in a different way than if you were late on your mortgage once or twice a year.
That’s the advantage of a full credit report. It’s not as clean and simple as a credit score, but it provides far more information. It still lacks context and the personal element, but in many ways, it says far more about you than one 3-digit number.
If you want to learn more about credit reports, check out credit report basics explained: Credit 101. The key to understanding credit, like anything else, is to do what you're doing right now. Read. Pay attention. Educate yourself. You'd be surprised how many people don't.
Closing Thoughts
Your credit score is important, but it’s not the most important thing about you. Not even close. If your score is pretty good, that’s great – keep doing what you’re doing. If it’s not what you’d hoped, that’s OK – there are ways to improve it. Far more important than your score right this moment is your score six months from now, and then six months after that. We can’t change the past – not without an Infinity Gauntlet or two, at least – but we can shape our own immediate futures. It’s not always fun, but it will pay off. I promise.
You don’t need fancy gimmicks or anyone’s paid program to improve your credit history. Just keep doing what you’re doing right now. Educate yourself. Revisit those tips above. Limit impulse buying. Make a household budget and get a better idea of what you can and can’t reasonably afford. There’s nothing magical about it – no insider tricks you have to know. It’s just adulting with a financial focus.
Finally, believe in your own power to change direction. I’m not talking some touchy-feely inspirational experience here. I just mean that sometimes the messages we send ourselves have more power than we give them credit for. Maybe I keep thinking, “There’s no point. I’ll never get out of this mess.” That sort of thing becomes self-fulfilling.
Something more useful, but still realistic, might be, “This is frustrating. It’s a lot of work to get control of my debt. I wish I’d done some things differently in the past, but I’m doing them differently now and that will just have to be good enough. It may take a while, but every day I make better credit choices, I’m one step closer to getting out of this mess even if I don’t always feel like it.”
You’ve started. That’s huge. So give yourself a little…
Credit.