Understanding the Basics of Credit, How Credit Works


by Ron Haynes

Credit is money loaned to you by a creditor, or lender, in return for a promise of future repayment, usually with interest added. Creditors include credit card companies, banks, and stores at which you have a charge card. Credit allows you to acquire goods and services before paying for them. In exchange, you agree to make regular and timely payments with interest on the outstanding debt you owe to the creditor.

Get your FICO Score with Score Watch® today! Click here! Your credit history, and the credit histories of every other American consumer, are collected primarily by three private, for-profit companies called credit bureaus or credit reporting agencies. There are three major credit bureaus:

  • Equifax
  • Experian
  • TransUnion

Credit Reports and Credit Scores

Using data they gather from your credit history, each credit bureau creates a credit report and credit score for you:

  • Credit report: A written report that includes entries on each of your credit accounts and credit “events” (such as a bankruptcy or tax lien), as well as any other information that may affect your credit. You can get one FREE credit report each year from www.annualcreditreport.com.
  • Credit score: A numerical score that is based on your credit history and reflects your creditworthiness. The score range is 300–850, with 850 marking absolutely perfect credit.

Click here and get your REAL credit score from myFICO.com.

Creditors use these credit reports and credit scores to make decisions about whether to grant credit to an applicant.

Credit Bureaus and Creditors

Creditors are the primary source of the information that credit bureaus gather, as well as the primary consumer of the product that the credit bureaus sell. The relationship between creditors and credit bureaus works like this:

  1. Creditors turn over data about your credit accounts to the credit bureaus.
  2. The credit bureaus process information from multiple creditors into credit reports and credit scores.
  3. The credit bureaus sell the credit reports and credit scores back to the creditors.
  4. Creditors (and others) use the credit reports and credit scores to evaluate applications from individuals for credit, insurance, employment, rentals, and so on.
Important Note:

It’s vital to get an official REAL score from myFICO.com. It is the gold standard and is the most widely used credit scoring company.

Other Sources of Credit Bureau Information

Credit bureaus also collect credit information on an ongoing basis from the following sources:

  • Debt collection agencies (agencies that collect debts on behalf of a creditor)
  • Public records

Other parties may report information about your accounts to the credit bureaus but only when your accounts are past due or have been referred to a collection agency. These other parties that may report your information include:

  • Landlords
  • Utility companies
  • Local retailers
  • Gasoline card companies
  • Insurance companies
  • Doctors, dentists, and hospitals
  • Other professional service providers

The Three Kinds of Credit

There are three basic kinds of credit: installment credit, revolving credit, and open credit.

Installment Credit

Installment credit refers to loans that require fixed payments at regular intervals. The amount you pay at each interval does not change. Installment credit is also sometimes called closed-end credit. Examples include:

  • Car loans
  • Mortgage loans
  • Personal loans (a loan from a lender that is not secured by any property)
  • Student loans
  • Recreational item loans (a loan for a boat, computer, RV, etc.)

Revolving Credit

Revolving credit allows you to use or withdraw funds at any time up to a specified dollar amount. At the end of each billing cycle (typically one month), you can pay back the balance in full but are required only to make at least a minimum payment, which is some portion of the larger existing debt. Any amount left unpaid is carried over to the next billing cycle, and interest charges are typically levied. Revolving credit is also sometimes called open-end credit. Examples of revolving credit include:

  • Credit cards
  • Bank account overdraft protection
  • Home equity lines of credit
  • Store-specific charge cards

Open Credit

Open credit is the term for accounts through which you pay for services rendered (as opposed to repayment of a loan). These accounts call for full repayment each billing cycle. Examples include:

  • Electricity
  • Gas
  • Other utilities

Your Credit History

Your credit history is a record of how you have used and managed credit in the past. Nearly every financial transaction in your life involving credit over the past seven years (and sometimes up to fifteen years) is recorded in your credit history—from your payment history on your credit card, to your history paying off your car loan, to any tax liens or bankruptcies you’ve endured. Lenders examine your credit history to determine whether to grant you credit and, if so, at what terms.

  • If you have a positive credit history — which means you repay your loans or other credit in full and on time — you’re said to have good credit. With good credit, you’re likely to qualify for loans with the most favorable terms, including the best interest rates.
  • If you have a poor credit history — which means you fail to pay back your loans or other credit either in full or on time — you’re said to have bad credit. With bad credit, you may have to settle for higher interest rates and larger down payments on car or home mortgage loans. In some cases, you may be turned down for loans entirely.

Your Credit Score

Your credit score, also called your credit rating, is a numerical score that’s intended to represent your overall standing with regard to credit. Credit scores are created by a proprietary mathematical model using specific data from your credit report. All three credit bureaus use similar scoring models to create credit scores.

How Creditors Use Credit Scores

Credit scores range from 300 (worst credit) to 850 (perfect credit). Some creditors use credit scores alone when making lending decisions, while others consider credit scores along with credit reports and other information. Either way, credit scores are usually used for multiple purposes in today’s credit environment:

  • To determine whether a creditor will lend money to a borrower: In general, anyone with a credit score below 620 is viewed as high risk and may be denied a loan. Some creditors may use an even higher cutoff.
  • To determine whether you can open a checking account: Banks are wary of  people with poor credit scores. Why? Anytime someone appears to have financial problems, a bank can be at risk. The bank runs the risk of NSF checks being paid but never having the funds deposited into the account.
  • To determine the terms at which a creditor will lend money: Creditors split the range of scores into levels: the highest level gets the best interest rates, and the lowest gets the worst. For example, say the best available interest rate from a particular creditor was 6.3%. The different rates available to different credit score levels might be:
Credit Score Interest Rate
760–850 6.30
700–759 6.53
680–699 6.70
660–679 6.92
640–659 7.35
620–639 7.89


  • To determine whether you’ll get hired: Yep, even employers are getting in on the act. Employees may be subjected to financial temptations that are difficult for those with poor credit scores to resist.
  • To determine whether you’ll get that apartment: Landlords are also learning the importance of credit scores. Tenants with superior scores may not live in a rental property for 5 years, but their payments will always be on time. Not so with a credit risk (there’s a reason someone is a credit risk and landlords know it).
  • To determine your car insurance premium: Insurers use credit scores to help them determine risk. Credit risks have been known to purposely wreck a car when the payments couldn’t be made, forcing the car insurance company to pay it off and allowing the insured to be freed from the financial obligation.

How Your Credit Score Is Calculated

Five factors are used to calculate your credit score.

  • Payment history 35%: Your record of bill paying. Your score reflects whether or not you’ve missed payments or paid late—and if you have, how recently, how frequently, and how severely (for example, if your account was sent to a collection agency). Though your payment history is the single most important factor in determining your score, an absence of late or missed payments will not guarantee you a perfect score.
  • Outstanding debt 30%: How much you owe, measured as a proportion of your outstanding balances to your credit limits on your revolving accounts (also known as your debt-to-credit-limit ratio). If your credit limit is $5,000 and your balance is $1,000, your debt-to-credit-limit ratio would be 20%. An acceptable ratio is anywhere below 30%; an ideal ratio is below 20%.
  • Length of credit history 15%: How long you’ve had credit. This includes the age of your oldest account as well as the average age of all your accounts. Generally, the longer you’ve had credit, the better.
  • New credit 10%: How recently you’ve applied for new credit and how many new accounts you’ve opened. Applying for lots of new credit in a short period of time can lower your score.
  • Types of credit 10%: The kinds of credit you have, meaning revolving credit (such as credit cards) vs. installment debt (such as car or mortgage loans). A mix of both types is considered most desirable.

Though all the credit bureaus use the same procedures to calculate your score, expect some differences in your credit score among the bureaus, as the information each bureau includes in your credit report may vary slightly.

Get your FICO Score with Score Watch® today! Click here!

Why Credit Matters

Credit is crucial to nearly every major financial decision you make, such as buying a car or a home. It’s also crucial to minor everyday money matters, such as buying lunch with a credit card. Since securing credit is such a key part of ensuring your financial freedom, it’s important to establish your reputation as a borrower by proving to creditors that you can pay back money you’ve been loaned.

Your Financial Reputation

The phrase your credit refers to your financial trustworthiness as perceived by a potential lender. It’s a measure of the lender’s confidence in your ability and intention to repay your debts. It might be helpful to think of your credit as your financial reputation:

  • If your financial reputation is good, lenders will want to lend money to you.
  • If your financial reputation is poor, lenders may be less willing to lend you money.

Financial Consequences of Having Good or Bad Credit

The lower interest rates people with good credit receive can result in tens of thousands of dollars in savings. For instance, a person with good credit may be able to get a home mortgage at an interest rate a full percentage point lower than the rate that a person with fair to poor credit may be able to get.

Over time, even a single percentage point can make a big difference. The table below illustrates the difference in monthly, yearly, and total costs for a 30-year fixed-rate $200,000 mortgage at 5.0% versus 5.99%:

Interest Rate Monthly Cost Total Interest Paid Total Cost of Mortgage
5.0% $1,073.64 $186,513.84 $386, 513.84
5.99% $1,197.82 $231,210.79 $421,210.79


Over the full course of this mortgage, having good credit results in savings of $34,696.95. That isn’t chump change … it’s after-tax dollars.

Credit can be a very complicated matter

But if you know the basics from this article, you’ll be able to navigate the maze of credit reports, credit scores, and the like well enough to take very good care of yourself, your finances, and your family.

Get YOUR Free Credit Score at myFICO. Click now! Why wait?

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