Credit

How Does Credit Work?

Your credit reports are documents that show your history with debt, over the last seven or more years.

Credit reports are meant to be factually accurate, sort of like a historical record that creditors can look at for a snapshot of your use of credit cards and loans. The reports may also have information about your non-debt related bills — including utilities, rent and hospital bills — if they go unpaid and end up being turned over to collections.

Here's what you'll find in a credit report:

• Personal information: Your name, date of birth, SSN, past addresses, employers and phone numbers.
• Credit card accounts: Limits, balances, and whether or not you've made the minimum payment each month.
• Loans: How much you originally borrowed, how much you owe, and your monthly payment history.
• Collections: Bills and debts that have been purchased by debt collection agencies, contact information for the collection agency, the amount you owe and when the information will be removed from your reports.
• Inquiries: The names of companies that have pulled your reports to pre-screen you for offers or determine if you qualify for new credit.
• Bankruptcy: The record of a bankruptcy can appear on your credit reports for up to 10 years after you file.

Most of the above information will be removed from your report after seven years and won't have much impact on your credit scores after roughly two years. But if the information is incorrect, you have the right to get it removed right away.

To remove errors, look for the "dispute" instructions toward the end of your credit report. Disputes can be filed for free by contacting the credit bureau online, over the phone or by mail.

Credit vs. Debt

The main difference between credit and debt is that credit gives you the ability to make a purchase now and pay for it later, while debt is the amount of money you owe at any given time.

For example, if you have only one credit card and you haven't used it yet, you do have credit but you do not have any debt. If you make a $50 purchase on the credit card, you now have $50 worth of debt.

On the other hand, as soon as you receive a loan you have debt. If your loan is $50,000, your initial debt is $50,000, plus any fees that you owe to the lender.

Types of Credit

Credit products can be further broken down into the following subtypes, and each one is a little different:

• Revolving credit: This includes credit cards and other accounts where the balance can revolve, meaning it can go up and down an infinite number of times when the user makes a charge or sends a payment.
• Charge cards: These are similar to credit cards, however there is typically no spending limit on a charge card and the full balance must be paid off each month.
• Retail credit cards: These credit cards are provided by retailers, such as clothing stores or large grocery chains. They're typically offered to customers at checkout as a means to access a store discount. Many customers don't realize these are real credit cards, often with very high interest rates.
• Installment credit: This is another way to describe a loan, or an account where the full balance is accrued up-front and repaid through monthly installments, or set monthly payments made over a period of time.

Why Is Credit Important?

Your credit reports and scores can play a direct role in your ability to get a new apartment, buy a home and save money on certain transactions.

That's because lenders, landlords and other entities often review credit reports to determine if an applicant is stable or reliable. Having no credit or poor credit or could make it difficult to do any of the following:

• Rent an apartment
• Take out a mortgage or car loan
• Gain and maintain security clearance
• Get affordable car insurance rates
• Open a utility account in your name
• Get hired for certain jobs (e.g. roles in the financial industry)

Having bad credit doesn't mean that you can't achieve any of the items listed above, but the lower your scores, the more difficult it can be.

What Is My Credit Score When I Have No Credit?

There's no such thing as a credit score of zero, but if you've never used a credit card or taken out a loan, you probably don't have a score.

In order to generate your first FICO score — that's the score that's most often used in credit decisions — you'll need an open credit account that's been reporting to the credit bureaus for the six previous months .

Once you reach that milestone, FICO will calculate your credit score. Their scoring range is typically 300 to 850 points, however some FICO score calculators range as high as 900.

How to Build Credit from Scratch

Building a credit score from scratch can be confusing, since it often takes credit to build credit. In other words, you have to have an open credit card or a loan in order to build up your credit scores. But there are a few great ways to start from scratch:

Become an Authorized User

This is the quickest and easiest strategy for building credit, since you won't have to apply or qualify for your own account.

Instead, you can ask a friend or family member to add you as an "authorized user" to their credit card account. Once they do, all their history and activity with the account will show up on your credit report — which can give your scores a major boost!

Tips: Make sure the person you ask has a history of on-time payments and maintains a low credit card balance. You can also let them know that you won't have a copy of the credit card or any access to their account.

Secured Credit Cards

If your credit is poor or non-existent, you can still qualify for a secured credit card by making a cash deposit. In return, you'll get a credit card with a limit that's equal to your deposit amount.

Usually these cards are available through credit unions for low deposit amounts, like $200 or $500, but the bigger your deposit (and spending limit) the greater the impact will be to your credit scores.

Tips: Before you apply, make sure the creditor reports account activity to all three of the major credit bureaus. Also, look for a card that has a "conversion option," meaning you'll eventually get your deposit back and convert the secured card to a regular, unsecured credit card.

Credit-Builder Loans

These loans are designed for people with poor credit. They're unique in that you don't receive the loan up-front. Instead, you make monthly payments and then receive the lump sum at the end of your payment period.

Like secured credit cards, these loans are widely offered by credit unions. But one drawback is that a credit-builder account is only active until your payment period ends. Credit cards, on the other hand, never have to be closed, so they can add positive information to your credit reports for an indefinite period of time.

How to Improve and Maintain Good Credit Scores

Credit scores are based on a relatively small handful of activities. These are the five areas that are weighted to determine your FICO scores, and how to gain points in each area:

• 35% Payment history: Make at least the minimum payment due to your creditors each month.
• 30% Credit Utilization: Reduce the balances on your credit card accounts and, if your account is in good standing, ask for a limit increase once a year.
• 15% Length of history: Plan to keep credit card accounts open for life and avoid frequently opening or closing accounts.
• 10% Applications: Limit your applications for new credit cards and loans, and when shopping around for a specific credit product (like an auto loan or mortgage), make all of your applications within a two-week period.
• 10% Credit Mix: You can get a small boost to your scores if you're managing multiple credit types (such as installment loans and credit cards) at the same time.

Note that some of the above areas matter far more than others. For example, a new application for credit will only cost around one to five points, but if you're 30 days late on just one credit card or loan payment your scores could drop by 100 points or more, and the missed payment will appear on your reports for seven years.

Getting Help with Your Credit Score

Building good credit requires a mix of healthy credit habits, having financial stability, and giving it time.

Unfortunately, many people wait until they urgently need good credit — whether for an emergency car loan, to buy a home that's already on the market, or otherwise — to pay attention to their credit reports and scores. And credit scores can't usually improve much on a short timeline.

Instead of waiting until the last minute, consider taking steps to start building good credit now. Fortunately, some of the best credit-building resources are free, including the federally-backed Annual Credit Reporting Service, where you can pull all three of your credit reports at no cost.

Professional support is also free when you work with a certified credit counselor, through a licensed, nonprofit credit counseling agency. Their services include credit report reviews, expert advice on how to improve your credit scores, debt management, and much more.