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How Do Your Credit Report and Scores Work?

Written by Allison Martin

Allison Martin is a personal finance enthusiast and a passionate entrepreneur. With over a decade of experience, Allison has made a name for herself as a syndicated financial writer. Her articles are published in leading publications, like, Bankrate, The Wall Street Journal, MSN Money, and Investopedia. When she’s not busy creating content, Allison travels nationwide, sharing her knowledge and expertise in financial literacy and entrepreneurship through interactive workshops and programs. She also works as a Certified Financial Education Instructor (CFEI) dedicated to helping people from all walks of life achieve financial freedom and success.

Updated February 19, 2024​

6 min. read​

how does credit work

You hear the term “credit” used a ton in conversation and are aware that it refers to borrowing money from a lender or creditor. But maybe you aren’t quite sure how credit scores are calculated, why they’re so significant, what it takes to build credit, or where to check your credit score.

This guide will teach you how credit works and the answers to these important credit-related questions.

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What is a Credit Score?

A credit score is a three-digit number that provides insight into your creditworthiness. It is calculated using the information in your credit report.

Approximately 90 percent of creditors and lenders use the FICO score, which ranges from 300 to 850) to make lending decisions. Here’s how scores are categorized:

  • Exceptional credit score: 800 – 850
  • Very good credit score: 740 – 799
  • Good credit score: 670 – 739
  • Fair credit score: 580 – 669
  • Poor credit score: 300 -579

Reasons Why Your Credit Score is Important

The most competitive financing terms are generally reserved for borrowers with credit scores of 670 or higher. Once you reach 740, your approval odds and ability to qualify for the best credit card and loan products on the market are even higher.

Beyond lower interest rates and favorable loan terms, credit matters for several other reasons:

  • You could get a lower auto insurance rate if you live in a state that allows insurance providers to use insurance-based credit scores to assess rates.
  • You could qualify for deposit waivers on a cell phone, cable, and utility services.
  • Your landlord may require a higher deposit if your credit score is low.
  • You could be turned down for employment if you have an unfavorable credit history. (Note: Employers are prohibited from accessing your credit score but can only view your credit report to make a hiring decision).
  • You could save a fortune in interest and use the funds to meet other important financial goals instead.

How Do Credit Scores Work?

Your FICO score is based on these factors:

  • Payment history (35 percent): Do you pay your bills on time? Lenders and creditors can report late payments once an account has been delinquent for 30 days or more. Late payments mean bad news for your credit score and can remain on your credit report for up to 7 years. Collection and charged-off accounts can do even more damage and should be avoided at all costs.
  • Amounts owed (30 percent): Your credit utilization plays a significant role in your credit health. It’s the percentage of your credit limit in use on each of your credit cards. Try to keep this figure at or below 30 percent to give yourself the best chance at a strong credit score.
  • Length of credit history (15 percent): This category considers the average age of your credit accounts and the amount of time you’ve used credit.
  • Credit mix (10 percent): Do you have a balance of revolving (i.e., credit card) and installment (i.e., loans) accounts? This is how your credit mix is determined.
  • New credit (10 percent): Hard inquiries, which appear on your credit report each time you apply for financing, can hurt your credit score by a few points. Too many hard inquiries in a short period could cause more damage. Furthermore, potential lenders and creditors could view you as a credit risk.
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Reading and Understanding Your Credit Report

Inspecting your credit report regularly is crucial for maintaining financial health. Identifying errors or recognizing fraudulent activity early helps you protect your credit score.

The Credit Score and Reporting System

As aforementioned, your credit score is a numerical representation of your creditworthiness. Financial institutions use this score, derived from the data in your credit report, to gauge the risk associated with lending to you. Credit scoring models vary, but they typically consider factors such as payment history and credit utilization.

What Can You See in Your Credit Report and What to Look Out For

Your credit report is a detailed summary of your credit history, including accounts opened in your name, payment history and credit inquiries. Regularly checking your credit report is recommended to ensure its accuracy.

Look for any discrepancies, such as accounts you don’t recognize or incorrect payment statuses, which could indicate identity theft or reporting errors.

Key elements to keep an eye on include:

  • Personal Information: Your name, address, and employment info should be up to date.
  • Accounts: Confirm that all listed accounts belong to you and reflect accurate balances.
  • Inquiries: Hard inquiries should only be from applications for credit you’ve consented to.

Effects of Late Payments, Bankruptcy, and Other Negative Actions

Negative financial behaviors, like late payments or bankruptcy, can severely impact your credit score. These marks can stay on your report for several years, signaling to potential lenders that you may be a higher-risk borrower.

Here’s a closer look at the potential negative outcomes:

  • Late Payments: They are typically reported after your account is 30 or more days past due and can tank your credit score by up to 100 points. The higher the credit score before the late payment is reported, the more significant the impact.
  • Bankruptcy: This negative mark remains on your report for 7-10 years, depending on the type of bankruptcy you file.
  • Collection Accounts: These accounts can result from unpaid debts and significantly damage your score once reported to the credit bureaus.
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What Is Credit Building and How Does It Work?

Credit building is a strategic process for enhancing your creditworthiness. It involves establishing a history of credit transactions and showcasing responsible financial behavior to improve your credit score. Here’s how you can approach it:

  • Secured credit cards: These require a security deposit typically equivalent to the credit limit, making it easier for you to get approval and build your credit.
  • Credit-builder loans: These are small loans held by the lender in an account while you make payments, thereby accumulating a record of on-time payments.
  • Authorized user status: Becoming an authorized user on someone else’s account allows you to benefit from their credit history without being financially responsible for the balance.

There are also several types of credit that can influence your credit-building efforts.

  • Revolving credit: This includes credit cards and lines of credit, where you have a credit limit and can borrow repeatedly up to that limit.
  • Installment credit: Loans such as auto, student, or personal loans fall into this category, which involves borrowing a fixed amount and repaying it over time.
  • Open credit: Utility bills and other regular payments also contribute to your credit history if you opt to have them reported by a third party.

How to Build and Maintain a Good Credit History

There are several ways to improve your credit score. Start by reviewing your credit report for errors and file disputes promptly with the credit bureau(s) reporting the inaccurate information. More on this shortly.

You should also highlight any negative entries so you’ll know what’s dragging your credit score down and devise a plan to fix it. This could include bringing any past-due accounts current to prevent more late payments and avoid the accounts being charged off. If you have collection accounts, it’s worthwhile to negotiate a pay-for-deletion agreement with the creditor or collection agency reporting the delinquency.

Here’s a closer look at ways to boost your credit health:

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Practice Responsible Credit Habits

To boost your credit health, always pay your bills on time. Timeliness in paying your credit card accounts and personal loans is noted by scoring models and can significantly impact your credit scores.

Pay Off Existing Bills, Loans, and Other Debts

One of the best ways to improve your credit history is by paying off your debts. This demonstrates to lenders that you can manage debt responsibly.

Get Current on All Past-due Accounts

If you have any accounts that are past due, bring them up to date as soon as possible. Late payments, especially those over 30 days late, can adversely affect your credit score.

Keep Your Credit Card Debt at or Below 30 Percent

High credit card balances can hurt your credit scores. Keep your balances well under 30 percent of your available credit limit to maintain good credit.

Don’t Close Old Credit Accounts

Keep older accounts open, as they can contribute positively to your overall credit history.

Only Apply For New Credit as Needed

Each time you apply for credit, an inquiry appears on your credit report. Limit the number of new applications to avoid negative effects on your credit score.

Check and Monitor Your Credit Report Regularly

Keep an eye on your credit report. Use your social security number to request a free report annually from each credit reporting agency to ensure accuracy.

Fix Mistakes and Inaccuracies on Your Report and Dispute Any Error

Review your credit reports carefully and dispute any inaccuracies or errors. Correcting these can positively impact your credit scores. However, fixing mistakes and inaccuracies on your credit report can be a complex and time-consuming process. That’s why enlisting the help of a professional like The Credit Pros is a smart choice.

The Credit Pros can assist you in disputing any errors or inaccuracies on your credit report. They have a team of experienced professionals who will work diligently to ensure that your credit report is accurate and free from any negative information. Whether you need help with credit report corrections, increasing your credit score, or establishing credit from scratch, The Credit Pros have the expertise to guide you through the process.

In addition to their exceptional services, The Credit Pros are accredited by the Better Business Bureau and have a stellar rating on Trustpilot. This demonstrates their commitment to providing reliable and trustworthy services. Furthermore, they offer a 100% 90-day money-back guarantee with affordable pricing and no long-term contracts, giving you peace of mind knowing that your satisfaction is their priority. Fill out a short form today or call (888) 558-1602 to get free consultations with no obligation to sign up.

By following these steps, you’re setting yourself up for a healthy financial future. Remember, building and maintaining good credit is a marathon, not a sprint, and requires ongoing attention and management.

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Frequently Asked Questions (FAQs)

How Does Credit Work in Simple Terms?

Credit is essentially a financial trust system that allows you to borrow money or access goods or services with the understanding that you’ll pay back the lender or creditor at a later date. When you apply for credit, lenders will assess your ability to repay the debt by examining your credit report and credit score, which reflect your financial history and how you’ve managed debts over time.

How Does Credit Build Up?

Building credit involves demonstrating your trustworthiness over time through responsible financial behaviors. Here are key actions to help you build up credit:
On-time payments: Always pay your credit accounts on time, as payment history is a significant factor in your credit score.
Credit utilization: Keep the balance low on your credit cards relative to your credit limits.
Diverse types of credit: A mix of different credit accounts, such as credit cards, personal loans, or mortgages, can show that you can handle various types of credit responsibly.
Length of credit history: The longer your credit history, the better it is for your credit score. So keep older accounts open in good standing even if you’re not using them frequently.

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