How Does Credit Work?

Credit is ubiquitous in this day and age.  It seems like some form of credit is used to make all our purchases.  Our houses are bought with a mortgage.  Our cars are bought with an auto loan.  Our electronics are bought with a credit card.  These are all prime examples of just how prominent credit is in our lives.

But how exactly does this credit system work?  In this article, we will attempt to delve into the world of credit and shed some light into how the credit system works.  In the interest of brevity, we will not go into corporate credit.  Instead, we will deal strictly with personal credit.

How the Credit System Works

So how does credit work? In its simplest form, the credit system is a trust system.  It is a three-way trust system between you, your creditor, and the credit bureaus.  Who is your creditor?  It is essentially any financial institution that lets you borrow their money, whether it is a credit card company, the government, or a mortgage lender.  This trust system is based on the implied acknowledgement that you understand that you are using someone else’s money and that it is your responsibility to pay it back.  And since there is an inherent risk in lending money, creditors charge an interest on the borrowed money to offset the risk, and more importantly, make money.

 Paying interest is sometimes unavoidable.  For instance, you are buying a house so you get a 30 year mortgage that is $200,000.  Because it is going to take you years to pay the mortgage, avoiding interest charges is not possible.  However, the upside is that when you sell your house you will be able to recoup whatever you have paid the banks along with some profit.  But there are times when paying interest is completely avoidable. This is usually true in the case of credit cards.  Credit cards purchases are small purchases that you should be able to pay back within a few weeks.  You should abstain from overusing your credit cards and always try to pay your credit card balance off every month to avoid interest charges.  The interest on credit cards is extremely high and there are virtually no benefits to carrying over a balance on your credit card.

Credit Scores and Their Role in the Credit System

Since there is inherent risk in lending money, there is a need for a streamlined method to properly assess borrower risk.  That is what credit scores are for.  It is a systematic way to assess a borrower’s risk of defaulting on debt obligations.  The lower the credit score, the more likely it is that the borrower is going to default.

By far the most prominent credit scoring system is the FICO score.  The FICO score formula was created by Bill Fair and Earl Isaac in the mid-1950s as a way to protect lenders from high-risk borrowers.   Although the formula has had some minor tweaks over the years, it has stood firm as the de facto authority in consumer risk assessment.

What Is A Good Credit Score?

The FICO credit score range is from 300 to 850.  A score 300 is the lowest possible score and 850 is the highest.  Generally, a credit score at or above 700 is considered a good credit score.  To really reap the benefits of having good credit, you always try to be at or above 740.  When you have a credit score of at least 740, you will be able to get the best rates available.

As of today, a credit score of 740 or above can get a 30 year mortgage with an interest rate of 3.260%.  Those with a credit score of 700 will still get a good rate, but it is at a rate of 3.500%.  If you are looking for to buy a home, try to aim for a 740 as it can literally save you thousands of dollars per year in interest payments.  If you have a credit score below 660, it will be especially hard for you to get a mortgage nowadays.  Gone are the days of unverified mortgages and bad credit mortgages. Those home loans died when the real estate market crashed. Banks are now more conservative in their mortgage approval process and regulators are now more stringent on lending practices.

A good credit score will also land you a lot of sweet deals on credit cards.  Many reward cards will only offer credit to those that have credit of 700 or above.  These rewards cards are extremely beneficial as you can get free hotel stays, flights, and discounts at all your favorite brands.  Although it is possible to get a credit card with a credit score below 600, those credit cards usually have low limits with extremely high interest rates and annual fees.

How Your Credit Score Is Calculated

The exact FICO score formula is not known but we do know what factors are used in generating a credit score.  Here are the factors that go into calculating your credit score.  The percentages indicate how heavily the factor is weighted in the calculation of your score:

Payment History (35%)

Your payment history is the biggest part of your credit score.  Paying on time helps your credit score.  Paying late hurts your credit score.  But there is a difference in what your creditor considers late and what the credit bureau considers late.  Your creditor will consider a payment late if it is made after the closing of your billing cycle.  Credit bureaus only consider a payment “late” if it is made 30 days or more after the closing of the previous billing cycle.  So even if you are late with your creditors, you may still not be “late” according to the credit bureaus.   So even if your creditor charges you a late fee for paying 20 days late on your payment, it will not affect your credit score.

In terms of late payments, the credit bureaus categorizes your late payments into four distinct categories: 30+ days late, 60+ days late, 90+ days late, and 120+ days late.  The later you are, the more adversely it affects your credit.

Payment history also takes into account any debt sent to collections, any debt defaults, any liens, or any bankruptcies you have filed for.  These factors are much more detrimental to your credit report than 30 or 60 day late payments so make sure they do not happen to you.

Debt-To-Credit Ratio (30%)

The amount of debt you have relative to the amount of credit you have is the second biggest factor of your credit score.  This ratio really only applies to revolving debt, mainly credit cards.   This ratio is also called the credit utilization ratio and can be easily calculated by taking the summation of all your credit card balances and dividing it by the credit limit of all your credit cards combined.  So if you have $5,000 in credit card balance across all your credit cards and you have a total credit card limit of $15,000, then your credit utilization ratio is .33 or 33%.  The higher this ratio is, the more adversely it affects your credit score.  Ideally, you want your credit utilization to be as low as possible.  A study done by found that there was an inverse correlation between credit card utilization rate and credit scores.  Essentially a lower credit utilization ratio equated with a higher credit score.  The study showed that those who have a credit utilization score between 1-10% had an average FICO credit score of 745.  Those who had a credit utilization of 91-100% had an average credit score of 591 according to the study.

Length of credit history (15%)

The length of your credit history is also a factor in how your credit score is calculated.  The longer your credit has been established, the more advantageous it is for your credit score.  This is why it is important not to close old credit accounts.  Closing old credit accounts will effectively erase a portion of your credit history.

Credit Inquiries and Acquisitions (10%)

Your credit score is also affected by how often you go looking for credit.  A credit inquiry is simply when a third party checks your credit score.  This could be for a number of reasons.  It could be because they are looking into approving you for a credit card.  It could also be because your bank is looking into getting you a mortgage.  Or it could even be a potential employer checking your credit score before hiring you.  It is important to keep in mind that only third party inquiries factor into your credit score.  Your credit score will not be affected if you are checking on your own credit report.

Types of Credit (10%)

The types of credit you also weigh on your credit score.  It is always good to vary up the types of credit you have (student loans, auto loans, mortgages, credit cards, etc.).  However, this does not mean it is a good idea to go and get a loan just to vary up your credit profile.

Credit Bureaus

The credit bureaus are the last piece of the credit system.  They exist to ensure the credit system functions properly by providing lenders with a risk assessment in the form of credit scores and credit reports. The three credit bureaus in the United States are Experian, Transunion, and Equifax.

Your creditors will report to the credit bureaus at the close of every billing cycle, which is every 30 days.  Essentially, they are telling the credit bureaus if you’ve paid or not.  All three credit bureaus use a variation of the FICO formula to calculate your credit score.  Your credit score and credit report will rarely be the same among the three credit bureaus because they do not all have the same information.  When trying to obtain a credit card or a loan, the creditor will first get your credit report from these three credit bureaus to determine your credit worthiness.

It is important that you always pay attention to your credit report and be cognizant of any inaccuracies.  The credit reports will often differ.  Your credit report from one credit bureau may be fine but another bureau may mistakenly report a credit account that you never opened.  Additionally, identity theft is rampant in this day and age.  Identity theft can lead to years of work in repairing the damage to your credit.  So be proactive and always monitor your credit report and immediately report any inaccurate or fraudulent information.

The Need for Credit

The term “credit” has gotten a bad rap as of late because of the economic turmoil many are experiencing. But what most people don’t realize is that credit is a form of financial leverage that has been extremely important in the growth and prosperity of the economy. Credit induces spending and spending supports economic growth. Credit in and of itself isn’t bad. With the right mindset, using credit wisely can lead to a road of prosperity. But with the wrong mindset, it can lead to a road of poverty and stress. They key to credit is to use it wisely.  Make credit work for you instead of against you.  Make it so that having credit benefits you more than it benefits the bank.  Use credit as a vehicle for wealth, not poverty.