how does credit work

You hear a lot about building credit, using it, protecting it and repairing it. At some point, you may have paused to wonder exactly what credit is, and how it works. Here’s your basic introduction to this vital engine that drives today’s consumer marketplace.

The word “credit” usually refers to a person’s ability to borrow money. When we talk about good or bad credit, it’s a shortcut for referring to someone’s track record on handling finances. Your credit score is a number attached to this track record. When you request a loan or a credit card, the lending institution considers the likelihood that you’ll pay back what you owe.

Your credit score tells the lender how big a risk it’s taking if it lends you the money. Like any investment, the bigger the risk, the better the payoff for the investor. For this reason, some lenders are happy to lend to people with poor credit, but they charge very high interest on the loan.

Years ago, the risk of conducting business deals was understood on a personal basis. Whether it was a neighborhood or a village, everyone knew who was good at following through on promises and who was irresponsible or unstable. People new in town might need to present a letter of reference to secure a job or a place to live.

Even now, if a friend or acquaintance asks to borrow something — your car, for example — you would probably think about their driving habits before you answer. Has he had accidents? Is he generally careful with his possessions? Does he keep his word? In today’s complex marketplace, we no longer know the people we deal with personally. Instead, we rely on credit bureaus to track people’s history and turn it into a single number that represents how much they can be trusted in the financial realm.

There are three main credit reporting agencies, or credit bureaus: Transunion, Equifax and Experian. These agencies gather information each month about your financial behavior. Anyone to whom you pay bills (credit card, utility bills, mortgage payments, auto loan installments, medical bills) reports to one or two of the credit reporting agencies. In addition to information on whether you pay your bills on time, the agencies also check on how much of your available credit you have used and the age of each account. Finally, they add in information about whether you apply for credit frequently and whether those applications are approved.

Each credit bureau usually has a slightly different version of your credit report, since each may receive information from different creditors. Your credit score is created by FICO or another credit-scoring company, using information from the credit bureaus. A high credit score tells lenders that you’re a good risk, so they charge you less to borrow money.

The fee for borrowing money is interest. With good credit, you can save thousands of dollars on a home or auto loan and pay less interest on your credit card. Conversely, a person with poor credit may end up paying 25 percent more on an auto loan, making that $20,000 automobile cost $25,000 over five years.

Taking out loans isn’t the only use for credit, however. In many states, your auto and home insurance costs are tied directly to a credit score that’s generated especially for each industry sector. A person with excellent credit may be charged only half as much as someone with poor credit for the exact same auto insurance coverage. It’s also standard practice for landlords to run credit checks on prospective tenants, and having poor credit can make it difficult to find a place to live. Prospective employers even check your credit score sometimes to see how responsible you are.

Credit reports are highly important, but unfortunately they often include errors. Your report may include information from someone with a similar name or someone who lived at your address before you moved in. A paid-in-full account may still show as owing due to the creditor neglecting to report the fact that you paid. There are numerous causes for errors, and each one needs to be individually disputed with each credit reporting agency.

Because errors are common in credit reports, it’s important to stay aware of what your report contains. You are entitled to one free credit report per year from each credit bureau from this federal government site. Many financial advisers suggest ordering a credit report from one bureau every four months so you have a higher chance of catching errors soon after they occur.

If your credit is poor, the good news is that it’s repairable. There are two approaches to repairing credit. You may only need one of these steps, but many people need both. The first step to repairing credit is to examine your credit report, find any errors and engage in a dispute process with the credit bureaus until they remove the incorrect content. The second step is to budget your money so you can pay all your bills on time.

Learning as much as you can about how credit works is a great foundation for building excellent credit. Your power to move through the financial world is dependent on your ability to handle the all-important tool of credit.

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