What is Credit?

Most of us have heard how important it is to have “credit.” But what is credit in a financial sense, and how does it impact your life?

Credit, put simply, is when you receive money today, with the expectation that you will pay it back later. Take credit cards, for example. When you put a purchase on your credit card, you are essentially borrowing the $30 for your new blouse, and your credit card issuer is expecting you will pay it back when the bill is due—or that you’ll pay them interest (and maybe penalties) for the privilege of extending your repayment period.

But credit is something you first have to earn. Here’s what you need to know about credit and how it affects your financial life.

Why do you need credit?

Very few people in the world can plunk down $40,000 for a car or…gasp…$250,000 for a home. So credit is handy for making big-ticket purchases—you can make a down payment of $5,000 for your car today and borrow the rest, then pay it back monthly (plus interest) over a certain period of time as determined by your lender. Having credit also offers convenience, such as when you use your credit card to buy lunch, knowing you intend to pay back the sum by the end of the month.

What is a credit score?

Credit allows you to borrow money with the expectation you will pay it back. And the reason lenders feel confident enough to lend you that money is because of your “credit score,” a three-digit number that’s a measure of your overall financial health. A credit score shows how you have handled debts in the past, and lenders assume you will follow a similar pattern in the future—whether that’s been positive or negative.

Your credit score provides a snapshot of how trustworthy they deem you to repay debts—the higher your score, the lower the risk of you not repaying them.

Your credit score can come from a variety of sources, but more than 90 percent of the top 100 largest lenders use a credit score called the FICO® score, which was created by Fair Isaac Corporation.

Wondering how high your score should be? FICO uses the following scale to rate your credit score.

Even though FICO is the credit score used most often, you will have other credit scores as well that might be used for various transactions. These are created by other credit bureaus that might tweak their formulas a bit and weigh factors differently, thus yielding slightly varying credit scores from bureau to bureau.

Lenders use this credit score to decide your interest rate, as in how much you pay them for the use of their money in the form of a loan. It will also dictate what your credit limits are, such as the amount you can put on a specific credit card or how much they will lend you to buy a home. Your credit score can also be used for decisions regarding employment and insurance.

What is a credit report?

A credit report contains the details used to calculate your credit score. There are three credit reporting bureaus in the United States— Equifax, Experian and TransUnion—and each of them creates a file on you that tracks all the details of your financial habits, the types of credit you have, your payment history and other factors as reported by those with whom you do business.

Every time you make (or miss) a payment or request new credit, the bureaus add it to your dossier, and then put all that data into an algorithm that determines your credit “score.” FICO and other credit scorers use this history they glean from your credit report, and then lenders will use the resulting score to determine if they want to lend you funds, and at what rate.

FICO uses the following model to determine your credit score:

Payment history (35 percent)

This slice—which has the biggest effect on your credit score—tracks whether you have made all the payments you promised and whether they were on time.

Credit utilization (30 percent)

This refers to how much credit you have available, compared to your limits. (It tracks “revolving credit,” which are lines of credit and credit cards—but not “installment” loans which are fixed loans, like your student loans or mortgage.) Experian recommends that you keep your balances below 30 percent of your available credit. That means that if you have a $1,000 limit on your credit card, you shouldn’t charge more than $300 per month.

Length of credit history (15 percent)

This references how long you have had credit, dating back to that very first credit card.

Credit mix (10 percent)

This element refers to the variety of accounts you have, such as credit cards, mortgages, auto loans or student loans.

New credit (10 percent)

This takes into account how much new credit you have applied for in a short period of time.

By noting the relative importance of different factors, you have a roadmap for how to build or improve your credit. Here are tips for earning a bump in that credit score on each part.

Payment history

You know the drill: Make on-time payments, every time. And put tech on your side by signing up for automatic payments so you never have to worry about a late bill again.

Credit utilization

If you have a $500 limit and spend $500 but pay it off every month, that’s great for your finances, but not so great for your credit, believe it or not. That’s because the credit agency looks at your statement balance, not the balance after you’ve paid your bill. If your amount looks high relative to your credit limit, that can ding you. A better option is to make two payments each month, which will keep the overall balance in check, or request a higher ceiling.

Length of credit history

Avoid closing a credit card you’ve had for a long time, even if you don’t use it regularly. One smart strategy is to set it up to make one of your small, recurring payments, like your Netflix bill, so the card is being used but you don’t have to think about it. (Just remember to pay it off each month.)

Credit mix

While you shouldn’t borrow just to boost your credit mix, having a few different types of credit can improve your score by showing you’re able to handle a variety of credit obligations. (Knowing that might take just a touch of the sting out of those student loans.)

New credit

As you wander the mall, it can be tempting to sign up for a number of new store cards.The perks! The points! But not only is it harder to track your spending when it’s spread out over multiple accounts, but all those new credit inquiries can mar your credit score. That’s because lenders jump to the worst-case scenario: What if you used all that credit at the same time? However, if you’re legitimately shopping for a mortgage loan or an auto loan, don’t be too concerned. The credit bureaus understand you’re comparison shopping, so when several inquiries come in from lenders or dealers over the same two-day period, they realize you’re actively shopping for a big-ticket item.

How can I find out what’s on my credit report?

So now that you know what goes into your credit score, you’re probably wondering what your credit report looks like. And that’s smart: It’s important to check those reports regularly—even if you have a light credit history—to make sure they are accurate.

In fact, errors are surprisingly common, finds the Federal Trade Commission. In its study of the U.S. credit reporting industry, one-quarter of consumers found an error on their credit report that could affect their credit score, which means they could be paying more than necessary for their mortgage or credit card interest rate. The good news is that four out of five of them had their file corrected after reporting the mistake, so it’s important to peek at your report to make sure there is no erroneous information bruising your credit.

Consumers are entitled to one free annual credit report from each of the credit bureaus every 12 months, available at AnnualCreditReport.com. Remember that each bureau reports different information, so make sure to review all three. A savvy tip to keep an ongoing handle on your credit is to request one from a different bureau every four months on a rotating basis.

Then, if you spot an error, make sure to report it immediately so that it can be investigated. According to the Fair Credit Reporting Act, the creditor must respond to your inquiry within 30 days.

As you peruse your report, you might be surprised to find that not everything you expected is there. For example, even if you faithfully pay your cell phone and gas bills, these providers typically do not report your on-time payments to the credit bureaus—although if you fail to pay and are sent to collections, that might be on your report. Also, only some landlords report your timely rent payments; if yours doesn’t, you can request they do so through a program like Experian RentBureau.

Note that you won’t find your actual credit score on the report; although you can find it for free through services like FreeCreditScore.com or WalletHub. Many credit cards also offer free credit scores as one of their perks. It’s a good habit to check it regularly so you can make sure it’s trending up—literally earning you credit where credit is due for all your hard work.

No matter where you are on your financial journey, credit matters. So take the time to understand what’s on your credit report and the steps you need to take to improve your credit score.