What is credit and how does it work?

How credit works

Here’s the catch with credit: You need to apply for credit to start building your credit history, but you need a credit history and proof of creditworthiness before most creditors will give you a credit card or loan.

The good news is there are ways around this dilemma. If you cannot qualify for a credit card or store card with a limited credit history, you can be added as an authorized user to someone else’s credit card or opt to co-sign a loan with someone you trust.

A creditor must determine your creditworthiness before granting you credit as a way of evaluating your risk level. Are you someone who is going to default on the loan, or will you be a good consumer that stays with them for many years?

Creditworthiness is typically broken down into five categories, known as the five C’s of credit, which include:

• Credit history: Sometimes referred to as character, this is your track record with past credit. Essentially this is asking: Do you pay your bills on time? Can you be trusted with the amount of credit you’re asking for?
• Capacity: This is where creditors analyze your ability to pay back any accrued debt. They’ll use things like your debt-to-income ratio to determine your capacity.
• Collateral: This comes into play for secured loans, like buying a car or home. In those cases, the physical item you purchase becomes the collateral, which can be seized if you fail to pay as agreed. For a personal loan, you may use assets you already own as collateral.
• Capital: For credit purposes, capital is any money paid in advance, like a down payment. These are common for vehicle and home purchases but won’t come into play if you’re simply looking to secure a credit card.
• Conditions: This refers to the factors and fine print of your credit or loan, including interest rates and repayment terms.

If approved, you should get quick access to the credit card or loan. What you charge on it becomes debt that must be paid back within the terms and conditions established by the creditor.

Credit report vs. credit score

Your credit report and your credit score are different things.

• Your credit report contains your credit history, current credit usage and a record of any late or delinquent accounts. They are offered by three major reporting bureaus: Experian, TransUnion and Equifax.
• Your credit score is a three-digit number that dictates where you fall on the scale of creditworthiness, ranging from poor to excellent. There are two scoring models commonly used by creditors: FICO and VantageScore.

While credit reports don’t generally include your credit score, you can check your score by using a credit report site. You can also buy access to your FICO score from myFICO.com. If you have a credit card, many offer free access to your score on a monthly basis.

» MORE: 9 ways to improve your credit score

Types of credit

There are three major types of credit.

Revolving credit

The most common type of revolving credit is a credit card. With revolving credit, you get access to a maximum credit limit, which is the total amount you’re able to borrow.

Most credit cards require a minimum monthly payment and allow any additional balance to transfer month over month. But it’s a good idea to pay off your total balance whenever possible. If you only make the minimum payment, or any payment less than the total balance, the balance that carries over accrues interest — and the interest rate on credit cards can be quite high.

Installment credit

Car loans, mortgages and student loans are common forms of installment credit. You borrow a specific amount of money and pay it off in equal installments over a set term, which could be months or years, depending on the nature of your loan.

Open credit

Open credit is a less common form of credit. Unlike revolving credit, open credit requires you to pay your balance in full each month. Examples of open credit include a charge card, not to be confused with a credit card, and utility accounts, such as your electric or water bill. The utility company “credits” you with electricity or water each month, and you pay your balance for what you’ve used when the month is over.

» MORE: Personal loan vs. credit card: Which is better?

What helps and hurts your credit?

Once you are approved for a line of credit, you want to maintain good financial habits that allow you to build your credit history and improve your credit score.

Here are the five factors that impact your score.

• Payment history: “One thing you NEVER NEVER NEVER want to do when trying to build your credit score is to be late on a bill,” said Taylor Kovar, a certified financial planner and CEO of The Money Couple. “Do whatever you can to make sure your credit cards, mortgage and anything else that reports to a credit bureau is paid in full and on time every single time. Being late just one time can cause havoc on a great credit score so set them all to autopay.” Late or missed payments can drop your score significantly and can remain on your credit report for up to seven years.
• Credit utilization: Keeping your credit card balance low in relation to your credit limit demonstrates responsible credit management. Aim to keep your credit utilization below 30% of your available credit. Carrying a high balance can lower your score.
• Length of credit history: The length of time you have held credit accounts is important. This is the average age of your credit accounts, so don’t close old accounts even if you don’t use them.
• Mix of credit types: Having a diverse mix of credit accounts, such as loans, credit cards and mortgages, can positively impact your credit score. It indicates that you can handle different types of credit responsibly. However, applying for too much credit at one time can hurt your score.

Will reporting rent to credit bureaus help my credit score?

Rent payments aren’t typically reported to credit bureaus by landlords. However, all three credit reporting bureaus say they will report on rent if they receive the information. The VantageScore and FICO 9 and later consider rent payments when calculating your score.

You can use free and paid services to get your rent reported to the bureaus, such as Fannie Mae’s Positive Rent Payment Program or Experian’s Boost feature.

Bottom line

The world we live in often depends on credit to get things done. Building your credit history and having a good credit score can certainly make your life easier in the long run. Having good credit helps you qualify for important purchases, such as a new car or your first home, and can be used by landlords, employers and utility companies to get a better idea of who you are.