How Does Credit Work? Understanding Your Credit Score

5 Min. Read

How Does Credit Work?

Understanding how credit works may feel like a mystery, especially if you have limited experience with credit. Your credit score and credit report are used in many ways, from getting a mortgage to buying a car.

 

If you were to Google “understanding credit” right now, you’d turn up more than 9 billion hits on the topic. That’s a huge amount of information to sift through! On top of that, you may not be able to tell what information is reliable and what is misleading.

 

Here, we’re helping you cut through the clutter by breaking down credit basics. We’ll cover how credit works, factors affecting your credit report, and how to raise your credit score.

 

What is a Credit Score?

A credit score is a personalized, three-digit number that demonstrates your creditworthiness. It’s calculated based on your credit history and used by lenders to assess the risk of lending you money and your likelihood of paying back debt. It factors into the type, terms, and loan amount you are approved for.

 

The most common type of credit score is the FICO score, which ranges from 300 to 850. The higher your score, the better your creditworthiness.

 

Why Credit Matters

Credit is one of the most important topics related to your personal finances. It consistently shows up and plays a crucial role in your financial well-being. That’s why it’s so important to understand your credit score and how credit works.

 

Your credit affects your ability to borrow money and influences the terms of the loans you’re approved for. Your credit score will be used by banks, credit unions, insurance companies, credit card companies, lenders, and others who evaluate your creditworthiness.

 

Lenders use your credit score to determine the likelihood that you will repay a loan or credit card balance. No credit or a poor credit score can hurt your chances of getting a loan. On the other hand, a good credit score can set you on the path to financial freedom.

 

Good credit can help you secure loans for major purchases like a home or car, get approved for credit cards, and even influence job opportunities or your ability to rent an apartment. Your credit score also impacts your interest rates, with a better score getting you a lower rate.

 

The Credit Score Explained

The three digits that make up your credit score hold a lot of power over the types of credit you can earn, the types of loans you may be approved or rejected for, and your spending limits.

 

You can have more than one credit score. Different credit scoring models and variations in data reported to the three major credit bureaus can result in multiple credit scores, so it’s common for your score to differ slightly across the reporting agencies.

 

Your credit score can fluctuate for many reasons. All the factors that influence your score—such as payment history and credit mix—can cause short-term and long-term fluctuations. You might see your credit score change frequently and seemingly for no reason. This is because creditors, lenders, collection agencies, and public records report new data daily.

 

What is a Good Credit Score?

A good credit score typically falls within the range of 670 to 739 on the FICO scale. Scores from 740 to 799 are considered very good, and scores of 800 and above are considered excellent. A credit score below 670 is generally considered fair or poor.

 

 

What Makes Up Your Credit Score?

Your credit score isn’t a mystery—it’s built from a few key factors, like payment history, credit utilization, and length of credit history.

 

Want the full breakdown? Learn exactly what makes up your credit score and how to improve it.

 

What Hurts Your Credit Score?

Maintaining a strong credit score also means knowing what can cause it to drop. Common pitfalls include missed payments, high credit card balances, and opening or closing credit accounts too frequently.

 

Want to learn more? Explore the top factors that can hurt your credit score.

 

Creating and Maintaining a Healthy Credit Score

You can start building, improving, and maintaining your credit score in many ways. Here are some of the most important things you can do to create and maintain a healthy credit score:

 

Make loan and credit card payments on time

Consistently paying your bills by the due date is one of the best ways to build and improve your credit score.

 

Spend responsibly

Be mindful of how much credit you spend and avoid maxing out your credit cards. Spend within a reasonable limit to ensure you keep up with on-time payments and avoid or reduce interest charges.

 

Pay down credit card debt

Reducing your debt by paying down existing balances can help lower your credit utilization ratio, which is a key factor in determining your credit score.

 

Keep old credit accounts open

Maintaining aged credit accounts will lengthen your credit history. Closing accounts too quickly can harm your credit score.

 

Limit new credit applications

Slow down on opening new accounts. Avoid opening multiple new accounts in a short period.

 

Regularly check your credit report

You can get a free copy of your credit report once every 12 months from each of the three major credit bureaus (Equifax, Experian, and TransUnion) through AnnualCreditReport.com.

 

Report any errors and dispute any inaccuracies

When you review your credit report, look for errors that may affect your score. If you spot any, report them promptly. Learn more about how to dispute an error on your credit report here.

 

Acquire a solid credit history with years of experience

There is no fast fix for building or repairing credit. The best way to improve your credit score is to acquire a solid credit history with years of experience.

 

A note of caution: Beware of companies that claim they can build or repair your credit fast. Unfortunately, many of these sources are scams. The only way to is to rely on positive behavior changes over time.

 

Make payments on time, aim to use less than 30% of your available credit, be careful about closing available lines of credit, limit the number of new accounts you open, and keep a mix of credit accounts. Combined with patience, these actions will put you on the right track to a good credit score.

 

What Should I Do if I See an Error on My Credit Report?

If you find an error on your credit report, you should:

• File a dispute with the credit bureau that issued the report.
• File a dispute with your credit card company or the creditor involved.
• If you suspect fraud, escalate your dispute to fraudulent claims.

 

Learn more about how to dispute an error on your credit report here.