How Credit Works

When I was a child, I heard everywhere that credit cards were evil.  My wife watched a film in school that was called “The Perils of Plastic.”  It talked about the dangers of credit cards, and taught her that they were “bad.”  The truth is that when they are used incorrectly it can negatively affect your future.

The reality is that credit is essential these days.  Without it most people would have a difficult time purchasing a home or investing in a good education. We use it for vehicles, boats, loans,  and much more.  It is a measure of your ability to pay people (banks) back when they lend you money. You need to make sure that you have a good credit score so you can use it to secure some free travel.

There are many scales that are used to determine your credit worthiness.  The most common scale that is used is called a FICO score.  This score has a range from 300-850.  Keep in mind that there are three different companies that issue you a FICO score, they are TransUnion, Equifax, and Experian.

You are entitled to receive a free credit report(without the score) every year from each of the three bureaus.  I would recommend that you space out those free reports all across the year so you are constantly watching for anything that might be a problem.  There are a lot of services that offer you credit monitoring, but I wouldn’t pay for one of those.  I’m too cheap.  I have found Credit Sesame to be very useful.  They provide the score to you (no report) at no cost.

I have personally applied for four different cards over the last calendar year and my Experian score has increased by 8 points in the last year.  Make sure you calculate your decisions.  I do recommend that you put your great credit score to work though 😉

FICO scores are determined by five different categories.  The pie graph below came from 

Payment History

  • Never miss a payment
  • Never miss a payment
  • If you are late…pay as soon as possible

Amounts Owed

  • Never owe more than 30% of your balance
  • i.e. Your credit limit is $10,000–Never owe more than $3000 at the statement closing date
  • You don’t have to carry a balance on your card in order to help your credit to grow.

Length of Credit History

  • This is what your average length is of all credit that you’ve ever been issued.
  • i.e. You’ve had your mortgage for 10 years, a credit card for 8 years, and one car loan that you had for 6 years.  You would add all of these up (10+8+6=24)  24/3=8 years would be the average length of credit history.  The longer this is the better.
  • For this reason we always ask you to keep your credit cards for at least one year.  Don’t cancel them immediately after getting the bonus.

New Credit

  • This is in reference to the amount of inquiries that you have on your credit report.  Each inquiry takes approximately 2-6 points depending on your scenario.
  •  When applying for a new account most credit card companies only check one of the three bureaus.  (Capital One checks all three)
  • Spread your inquiries amongst all three of the companies.  You can ask us if we know which card pulls from which agency.  If we know, we are more than willing to help.

Types of Credit Used

  • Credit Cards, Mortgages, Charge Cards, and Finance Accounts are all different types.  They want to see that you have a variety of these accounts.

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