Most of us have a better chance of being servants to credit rather than mastering credit. With over 77% of Americans are in debt (United States Census Bureau), something needs to change. Unfortunately, that means if you are reading this article, you probably know how difficult mastering credit can be. If you ever want to be able to buy a house or car, chances are you will need to understand, utilize, and master credit. Credit isn’t only used for significant purchases. It is used in our day-to-day by influencing the following:
- Landlords/Property managers can check your credit to determine if you are eligible to rent the property and how large of a security deposit they require.
- Insurance companies can use your credit scores to determine how much you make and ultimately how much you pay for coverage.
- Utility companies can use this information to determine if you can open an account with them.
- Prospective employers can look at your credit score for hiring purposes
- It can also be used to verify your identity.
Ultimately, credit is a fantastic tool for building wealth, but it also has the potential to completely tear your financial house down. With a bit of knowledge and application of principles, you will be on your way toward mastering credit.
What is credit?
Mastering credit starts with understanding what credit is. Simply put, credit is the ability to purchase something, borrow money, or gain access to goods or services today with the promise to pay it back at a later date.
Creditors, which are lenders, merchants, or service providers, offer you a given amount of credit based on how confident the creditors are you will be able to pay it back plus any interest or fees associated.
In the past, there was no objective way to measure how likely you were to be able to pay back your debt. Creditors used reputation or relationship alone to issue credit. Obviously, that method is not accurate and prone to various errors.
Thankfully, we have a better way to gauge how much money a person can reasonably borrow or how much credit a person is now eligible to receive, thanks to the invention of credit scores. We will cover this later in the article.
Types of Credit
The four types of credit available to you are revolving credit, charge cards, service credit, and installment credit. We will focus on the two primary forms of credit that affect your credit score the most: revolving and installment.
- Revolving Credit: When you hear revolving credit, think about the way credit cards work. You are given a credit limit or the maximum amount this creditor will provide you, and you must make at least the minimum monthly payments based on how much of the credit you actually used. Revolving credit typically doesn’t have a fixed term which means as long as you are making the payments and not exceeding the credit limit, you are able to keep using the credit indefinitely.
- Installment Credit: Great examples of installment credit are student loans, personal loans, and mortgages. In these loans, you borrow a fixed amount of money and agree to make fixed payments on it until the overall balance with interest is paid off.
5 Key Factors Affecting Your Credit Score:
Maximizing your credit score is critical to mastering your credit. A credit score is a number given to you by a credit bureau; the three main credit bureaus, TransUnion, Equifax, and Experian, determine the risk that you will not pay your credit obligations. The number can range from 300 to 850, where the higher the number, the lower the indicated risk. These five factors together are responsible for your credit score:
1) Payment History (35%)
Payment history is the most heavily weighted on the list, and for a good reason. Creditors want to know whether you have paid your past credit accounts on time and if you have defaulted on any debts.
2) Amounts Owed (30%)
Just because you owe money does not mean you will have a lower credit score. Amounts owed are more related to how much of your available credit you are using. Banks, like us, want margin. The less we use our available credit, the more the bank feels comfortable giving us more credit. Typically using 30% of our available credit or less maximizes our score here.
3) Credit History Length (15%)
Your score takes into account how long accounts have been established, how long since you have used certain accounts, the age of your oldest account, and several other factors.
Generally speaking, the more extended your credit history, the more positive its impact on your score.
4) Credit Mix (10%)
The more types of credit you have, the higher its impact on your score. You do not need to have one of each type, but generally speaking, a couple of credit types is suitable for your score.
5) New Credit (10%)
Opening too many credit accounts in a short time is viewed as risky to the banks, especially for those who have a relatively short credit history.
Credit Pitfalls To Avoid
We just covered how your credit score is formed. Now we need to talk about some of the most common ways to hurt your credit.
- Missing payments. With your payment history accounting for over 35% of your credit score, this is the easiest way to hurt your score quickly. Even just one missed payment can have a negative impact on your score.
- Using too much of your available credit. When using a credit card, it is very typical that we come close to maxing out our spending limit; this is not wise and hurts our credit score. When utilizing credit, realize that you will have to pay this amount back, so only spend it on things you can afford. Shoot for using 30% of your available credit as your new credit limit, and your score and finances will thank you.
- Applying for too much credit too fast. Again, banks and creditors are all about measuring and gauging risk. Each time you attempt to open a new line of credit, it shows the credit bureaus and stays with your account for two years. If you are opening or attempting to get credit from multiple sources quickly, this indicates risk for them.
- Defaulting on accounts. Not paying your debts will dramatically affect your credit score for years and potentially longer than this. Whether it be bankruptcy, foreclosure, or any number of debt defaults, creditors do not like to see this.
Improve Your credit
Improving your credit can be much easier to do once you understand how your credit score is actually being created. Regardless of where your credit score is today, with some hard work and potential behavior changes, you can begin mastering your credit. Here are a few helpful tips to get started on improving your credit!
- Pay your bills on time. Payment history is the most important factor in your credit score, so making payments on time every month will dramatically improve your score over time.
- Pay down debt. One of the quickest ways to improve your credit score is to increase your financial margin by paying off debt. Focusing on credit card debt is typically the easiest place to start with. Using less of your available credit will boost your score quickly while reducing the amount you owe in the future.
- Make any outstanding payments as soon as possible. Making outstanding payments improves your credit immediately and also stops you from paying additional interest. You work hard for your money; make sure your money works hard for you.
- Check your credit score and dispute any inaccurate information. You are entitled to one free check a year so take advantage of this opportunity!
- Limit new credit requests. Grow the credit you currently have rather than request new lines of credit. Your credit score will thank you, and your creditor will be more likely to work with you this way.
Bottom Line:
Hopefully, credit doesn’t feel as scary now that you are armed with how it works and affects you. Remember, credit is a tool. It is not inherently good or bad. Use it with confidence and discipline, and you will be very happy you did. As always, you got this!
