Credit plays an increasingly bigger role in your life as you advance your career and reach for more milestones. Think about all the things you might want in the near future. Everything from a house to a business loan to a new cell phone plan. Your ability to access all three would depend on your personal credit score. If you use your credit wisely, your financial limitations will put less restrictions on your purchases and other goals. Simply put, perhaps the greatest reward of proper credit management is always having more credit at your disposal.
Many people, especially business owners, believe that understanding credit just means knowing how to achieve an excellent credit score. But the actions that produce excellent credit aren’t the only actions that affect your credit. When you know how credit works in general, you can make smarter spending decisions and grow your business and credit simultaneously.
In this guide, we’ll explain the different types of credit, the components of your credit score, and how to improve and build credit throughout your career.
How Credit Works In General
Credit bureaus create your credit report by collecting information about your credit usage after you open a credit card or apply for a loan. Five elements of this information are then used to calculate your numerical credit score: payment history, credit utilization, credit mix, length of credit history, and applications for new credit. Your credit score determines your ability to qualify for various forms of financing.
How Does Credit Work? Borrowing Fundamentals
Consumers acquire credit when they borrow money from financial institutions, most notably credit card vendors, banks, or business lenders. The institution, or “creditor,” reports the amount borrowed, the agreed-upon repayment schedule, and the size of each payment to credit bureaus. This information then appears on the individual’s credit report. In addition to credit cards, applying for and paying back virtually any sort of loan affects your credit score. This could be for your business, your car, your house, or your college tuition.
Your credit score therefore acts as a representation of your ability to pay off debt. This is why financial institutions and property management companies look at your credit score before approving your application. They want to gauge the likelihood of you fulfilling the terms of the agreement, like the size of the monthly payment and the due date for paying off the full amount.
Business lenders devote an especially large degree of attention to credit score because small businesses fail all the time. This might not seem fair because you are applying for a business loan, not a personal loan. But when you start a business, you are accepting full responsibility for the business’s potential failure. It was your decision to start the business. All in all, entrepreneurship is really another personal financial venture.
Types of Credit
Though you can secure many different types of agreements with creditors, there are two main types of credit accounts. They differ primarily in how they process payments and how they are recorded on your credit report. The two accounts are installment credit accounts and revolving credit accounts.
If you know how a traditional business term loan works, you know the basics of installment credit. There’s a specific due date and repayment schedule. The agreement likely outlines how many monthly payments you’ll have to make in order to pay off the debt in full.
Most car loans, student loans, and mortgages are installment credit accounts. The terms are long because the monthly payments are relatively small. So, during the first few years, your credit utilization ratio will likely be very high because you’ll owe a lot of money and will only have paid back a small portion of it. Towards the end of the term, however, your credit utilization ratio will significantly decrease. That’s a key tenet of installment credit accounts: When the end of the term approaches, you’ll have much less money to pay back.
Revolving credit is most often associated with credit cards and business lines of credit. You have a credit limit and minimum monthly payments that begin as soon as you use the available funds. Interest accrues every month as long as you maintain an outstanding balance (continue to owe money). Borrowing more money increases your interest as well. You pay interest for the convenience of being able to make large purchases without having to actually pay for the majority of it until much later on.
And when you pay back what you owe, that money becomes available again. For example, let’s say you have a $12,000 credit limit and you use $10,000. At that point, you’d only have $2,000 left to use. But if you pay back $8,000, you now have $10,000 to use again.
This can be confusing and dangerous for people who have used most of their credit but only make minimum monthly payments. In this case, most of your monthly payment would go towards interest, so you wouldn’t be paying off as much of your balance as you might think.
Types of Borrowers
Though most credit cards and lines of credit are revolving accounts, many borrowers do not use the revolving function at all. For this reason, creditors categorize borrowers into two groups: transactors or revolvers.
Here’s the main difference between the two:
Transactors borrow a certain amount every month and then pay off their full balance that same month. They have no interest on their accounts because they always pay back what they owe within a month’s time. In addition to saving money, being a transactor protects your credit score because you owe nothing and have plenty of credit available.
Thus, people who need to maintain excellent credit scores (i.e. business owners) might open new credit accounts solely to become transactors. These borrowers typically use the funds for one purpose, like covering a fixed business expense every month. Constantly paying off the full balance acts prevents their other credit activity from hurting their credit score.
Most borrowers are revolvers because they carry a “revolving” balance month to month. They make small monthly payments and carry much larger balances, usually within the thousands. Being classified as a revolver denotes that you probably don’t have the financial capabilities to increase your average monthly payment by much.
Though it’s perfectly feasible for revolvers to maintain a good credit score, the massive gap between their outstanding balance and their monthly payments makes their score very sensitive. In this case, just one missed payment could significantly reduce your credit score.
Why Do These Things Matter?
The two previous sections (types of credit, types of borrowers) highlight additional information featured on your credit report. Financial institutions will consider both factors when deciding whether to approve your credit card, loan, mortgage, etc.
Earlier, we mentioned that one of the elements of credit score is “credit mix.” Some borrowers mix up their credit by managing one installment account (like a business term loan) and one revolving account (like a business line of credit) simultaneously. Also, the existence of the “transactor” status shows that you can take another step farther to impress credit bureaus and protect your credit score. Someone who isn’t aware of transactors might assume credit bureaus would find it unnecessary to open another account solely for this reason.
In summary, the type of borrower you are and the type of credit you use provide more insight into your capacity as a borrower.
How Does Credit Work? Credit Bureaus and Credit Reports
Your credit report reveals how you acquired and paid back the most important purchases of your life. People have similar goals (house, wedding, etc.) but everyone goes about achieving them in different ways. The methods you chose to achieve your goals and how they affected your financial future can be viewed in your credit report.
But this isn’t a story we get to tell on our own. Instead, your credit report is composed by the three main credit bureaus: Experian, Equifax, and TransUnion. These agencies create reports by collecting information and summarizing it to give financial institutions all the criteria they need to make credit-related decisions.
Each agency has its own method of collecting information. They might collect different pieces of data at different times. And the information each agency collects depends on whether the institution reports to that agency. A credit card vendor, for example, might report to a different agency, or fewer agencies, than a business lender or mortgage company. But no matter which bureau you get your credit report from, each version will most likely look the same.
According to federal law, all individuals are permitted to one free credit report from each bureau every year. Taking advantage of this law is crucial for improving your use of credit and understanding how you’ve arrived at your current score.
Credit reports from the three bureaus look alike primarily because they all use the FICO scoring system.
How Does Credit Work? Calculating Your Credit Score
Your credit score condenses all the information in your credit report into a three-digit number. Thanks to this number, institutions don’t have to go through your entire credit report to see how likely you are to make timely payments. Your credit score tells them how long you’ve been using credit, the types of accounts you have, and how you’ve handled the responsibilities attached to those accounts. The height of your credit score can therefore reflect your likelihood of making timely payments.
All credit bureaus use the FICO algorithm because it ensures that credit scores are calculated through a standardized procedure. The formula incorporates numerous elements of your credit history and is therefore fairly complex.
The FICO Algorithm
The name “FICO” comes from the Fair Isaac Corporation, which designed the algorithm in 1960s. It primary purpose is to determine the likelihood of a borrower defaulting on debt payments within the span of 18 months. Borrowers with lower credit scores are therefore more likely to default in that time period, while borrowers with higher credit scores are less likely to see this outcome.
The highest possible score is 850, and the lowest is 300.
- Excellent: 740-850
- Good: 680-739
- Fair: 580-679
- Poor: 500-679
- High Risk/Untouchable: 499 and under
As long your credit score falls within the “good” range, you shouldn’t have much trouble accessing business loans, new credit cards, etc.
The exact components of the FICO algorithm are not public. So, outside of the three bureaus, no one really knows how a credit score is calculated. All we know is the criteria the bureaus factor into their calculations, and it’s broken into five categories.
Let’s go over all of those, from the most important to the least:
1. Payment History (35%)
No single factor has more influence on your credit score than your past payment history. Thus, the timing of your payments can either significantly help or hurt your score. Rule number one for building and maintaining excellent credit is to always make payments on time.
Since timely payments are so important, your credit score increases when you have as many timely payments as possible. You can accomplish this by establishing timely payment histories with multiple credit lines. On the other hand, the amount of damage inflicted by missed payments depends on a variety of factors. This includes how late the payment actually is, how many times it’s happened before, and your outstanding balance. As mentioned earlier, if you have a high balance and only pay the minimum payment every month, one missed payment could be costly.
If you miss a payment, your credit score will decrease every 30 days you go without paying your minimum. The first real hit will therefore occur 30 days after missing your payment. If you go another 30 days (60 days total) without paying, the damage will be much worse. The cycle continues for 90 days, 120 days, etc.
You can gradually recover from missed payments by establishing a long record of timely payments moving forward. Even if you’ve missed multiple payments, a newly impeccable payment history can still build your score back up. In fact, all late payments get erased from your credit report with seven years after the first due date was missed. For this reason, it’s much less hazardous to have one missed payment on your record from years ago than to have recently missed a payment.
2. Amounts Owed (30%)
This refers to the total amount of credit you owe, or the sum of your outstanding balances. The amounts owed category also factors in your credit utilization ratio, or the ratio between your outstanding debts and your credit limits. Your credit utilization ratio can offset a high outstanding balance, low monthly payment, or other potential signs of poor credit.
Each account has its own utilization ratio, and the ratios for some accounts will impact your credit score more than others. For example, installment credit accounts tend to have fixed ratios because you’re supposed to make the same payment every month and the ratio directly depends on the account’s due date. Hence, ratios for installment credit accounts will have less impact on your credit score than revolving accounts. Credit cards and lines of credit have borrowing limits but unlike installment accounts, you can repeatedly borrow and pay back as much as you want each month. In other words, you have much more control over how much you borrow and how you pay it back.
So, if your credit report shows a revolving account with a high utilization ratio, it probably means you owe a lot of money and have accrued a high interest rate. Borrowers of this nature typically use their credit cards too often and perpetually owe more money than they can afford to pay back. These habits make someone statistically more likely to default on a payment.
A good credit utilization ratio should not exceed 30%. If your credit limit is $20,000, a credit utilization ratio of 30% would mean you never borrow more than $6,000 at a time if you already have an outstanding balance.
3. Length of Credit History (15%)
It’s nearly impossible to achieve a good credit score with little credit history to go by. The FICO algorithm works in your favor when it has more data to use. Even if you rack up six months of timely payments, the algorithm still doesn’t have enough data to confidently predict that you’ll be just as responsible with a loan or credit card.
In order to gain enough data to build good credit, you must have an account open for at least one year. Thus, you essentially have no choice but to tough out that first year with a lower credit score.
4. New Credit/Credit Inquiries (10%)
Many borrowers do not understand why opening a new credit account automatically hurts their credit score. It’s because pulling your credit report from multiple bureaus tells the FICO algorithm that you will soon be borrowing more money. Your score will go down a few points but should begin to recover after about six months of timely payments. After two years, the damage from the credit pull will disappear from your credit report.
Checking your own credit score, however, will not hurt your score, no matter how many times you do it. You can also find institutions perform soft credit pulls instead of hard pulls to minimize the impact on the borrower’s credit.
5. Credit Mix (10%)
As long as you make timely payments, opening a wider variety of credit accounts only helps your score. This gives the FICO algorithm more data to create an accurate prediction of how you’ll handle future accounts. The algorithm therefore favors borrowers who are currently paying back credit cards, mortgages, and/or business loans simultaneously. Proving your ability to manage multiple types of accounts shows that you will most likely have no trouble managing your next account, no matter the type.
Think about it: The likelihood of someone missing a car payment is low because it carries dire, immediate consequences. The likelihood of missing a credit card payment, however, is higher because there’s few (if any) immediate consequences. Hence, a borrower whose only account is a car payment would not score well in the credit mix department.
How Does Credit Work? Fixing Errors On Your Credit Report
Unfortunately, mistakes appear on credit reports all the time. Your report could say that you owe more than you actually do, or claim that you missed a payment despite your flawless record. But you wouldn’t know unless you check your credit report regularly, or at least once a year. It’s your responsibility to spot the error and get it fixed. You can either contact the institution associated with the account or contact the bureau that created the report.
Borrowers often avoid checking their reports out of fear that they’ll see something they don’t like. But aside from making timely payments, keeping your utilization rate low and opening a variety of accounts, this is really all you have to do to ensure an excellent credit score. You simply must check your report, even if you have no reason to believe an error has been made.