What Is Credit & How Does Credit Work [In-Depth Guide]

what is a good credit score?
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Credit affects numerous aspects of our lives, both financial and otherwise. Therefore, it is essential to focus on how you can improve your credit and credit score. You can achieve a good credit score by building good financial habits and paying bills and debts on time. 


Credit is deeply embedded in our financial structure. Even though a lucky few can make large purchases, such as buying a house or car outright, most individuals rely on credit and auto loans to make such big purchases. 

However, what’s important to understand is that credit is not just for taking loans. Your credit score and creditworthiness go much beyond that and can be used as a measure by employers, rentals, and even insurance companies to assess your reliability and financial behavior. 

Therefore, all individuals must improve and maintain a good credit score and engage in financially healthy habits. But before we get to the “How?” let’s first understand what exactly credit is and how it can help us. 

What is Credit?

Credit is an individual’s ability to borrow money or gain access to certain services and goods that they will pay off later or over time. Creditors are individuals that lend money and services in the form of credit. Creditors can be service providers, merchants, lenders, and even banks. 

For a creditor to allow you to borrow money or services, they must be confident that you will pay back the borrowed amount and any additional charges they might apply back in the mutually decided time. 

This trust and vote of confidence that creditors rely on are called “creditworthiness.” For creditors to be sure that they can trust you with their money, you need “good credit.” 

What are the Different Types of Credit?

There are three different types of credit accounts that you can utilize. They are as follows: 

Revolving Credit

The first and most common type of credit account utilized by individuals is revolving credit. This type of credit allows individuals to access or borrow money from financial institutions up to a mutually decided limit based on creditworthiness and other factors. 

Towards the end of your statement period, which is a predetermined amount of time according to which you will pay your balance (usually a month), you receive your bill. Individuals must pay a minimum amount if they want to avoid penalties and extra charges that could damage their credit. But, if the bill is not fully paid during that time, the card issuer carries the balance over to the following month. Individuals will have to pay the required interest on that amount accordingly. 

This type of credit account carries an advantage because individuals have adequate flexibility in choosing the amount of money they would like to borrow monthly. The amount can be revolved to the next month if it is not paid in full. A revolving account is especially useful for managing budgets and covering unexpected expenses when emergency funds have diminished. 

However, it must also be kept in mind that such credit accounts are more beneficial for short-term financial commitments. The monthly interest is higher for credit cards used in such cases, making using a revolving credit account for long-term commitments and large purchases an impractical decision. 

The best examples for revolving credit accounts are credit cards, Home Equality Lines of Credit (HELOC), and even personal credit lines. 

Installment Loans

Installment credit or installment loan accounts are entirely different from revolving credit accounts. Where revolving credit is mostly used for short term expenses, installment credit accounts are a better option when long-term financial commitments are made. 

In the case of an installment loan, the financial institute gives customers money upfront. Any interest or additional costs associated with the installment loan are included in the bill. The final amount is to be paid by the customer over a predetermined period. The amount is usually repaid in equal payments (installments) spread across a period (often given monthly). 

Installment loans allow individuals to make large purchases that they might be unable to fund right away. So, although the final loan amount may be higher than what the customer would have had to pay originally, it is often more feasible. 

This, coupled with the low-interest rate of installment loans and a regular schedule for payments, makes installment loans an attractive option for many individuals. It allows people an easy opportunity to budget in large purchases that they would otherwise not make. 

Types of Installment Loan Credit Accounts

Common examples of an installment loan credit account include mortgages, auto loans, personal loans, and even student loans. However, it must be noted that interest rates are generally higher than others for personal loans. But they are still an excellent option for debt consolidation and emergency funds. 

Open Credit

The last type of credit account is an open credit account. Such accounts usually require individuals to pay the balance in full by the end of the month. However, there is no credit limit. 

A typical example of an open credit account is a utility account. These accounts don’t have a fixed balance that needs to be paid. Nonetheless, whatever balance is present must be cleared each month to continue usage of the utility service. 

Other types of open credit accounts include charge cards. Charge cards are different from credit cards. There is no present limit with charge cards, and the amount that individuals charge on the card can vary. 

This amount is dependent on numerous factors, such as your payment history, credit score, etc. However, you must pay the final balance in its entirety to avoid hefty penalties or closure of the account at the end of the month. 

Currently, the only significant financial institution offering this service is American Express. Their Business Platinum Card®, Business Green Rewards Card, and their Plum Card® are all examples of charge cards. Other than American Express, charge cards can also be provided by individual merchants. 

What is a Credit Score?

An individual’s credit score is based on their length of credit history and is included in their credit report. Your credit score must not be confused with the credit report. The credit report contains much more information and is reflective of your entire credit history. Your credit score is a part of this report as well. 

On the other hand, your credit history contains information about all the loans and credit cards that you have signed up for in your life. It includes everything from your very first college credit card to your most recent loan. If you have any judgments, foreclosures, or late payments, they will be included as well.  All of this information will be compiled into your credit history and determine how well you have paid your past bills. This payment history is used to ascertain your credit score. 

Your credit score is a three-digit grade that helps lenders determine whether you will pay future debts with ease. 

The three largest and most trusted credit bureaus in the United States are Equifax, Experian, and Transunion. The three companies gather all of your credit history and information from different authentic sources, combine them to form a report, and then assign a credit score to you. 

In the end, all of this information is made available to lenders and financial institutions to help them determine whether they should trust you enough to lend you their money or services. 

The credit score assigned to you can range anywhere from 300 up to 900 in most cases. This score helps lenders determine how responsible you are with your finances and how well you have previously managed your credit history. 

There are four main types of credit scores used by the bureaus:


By far the most popular method for credit scoring, FICO uses payment history, credit age, debts owed, any new credit or credit inquiries, and the types of credit utilized by individuals in the past to calculate a score that accurately reflects a person’s creditworthiness. Owing to the FICO score’s accuracy, nearly 90% of all the top creditors in the US utilize it. The score’s range is 300-850.


Closely following the FICO score is the Vantage score. This popular credit scoring method has been created by a union of all three major credit scoring bureaus. The Vantage score is calculated by considering payment history, the type of credit account, credit age, the utilization of credit, total balance, available credit, and credit behavior. Its score also ranges from 300 to 850. 

Empirica Score

The Empirica score is a credit score designed by the giant credit bureau Transunion. This score is based on the FICO score. It is made available to lenders to assess the creditworthiness of individuals before they grant loans or other services to them. The score’s range is 150-934. 

Beacon Score

The Beacon score has been designed by Equifax, one of the largest trademarked proprietary crediting bureaus. Like the Empirica score, the Beacon score also helps lenders determine how creditworthy an individual is through its ranking process. Equifax uses the data it has collected about the individual to calculate an appropriate score for them. The Beacon score’s range is 280-850. 

What Is A Credit Report?

A credit report is a detailed report that helps creditors assess your creditworthiness and offer you credit on its basis. In other words, your credit history and report can help make or break your appeal for credit. The better your credit report, the more chances you have of your credit request being approved on favorable terms. 

As mentioned before, your credit report reflects your credit history and how well you have managed credit previously. Since this information is collected and evaluated by the three major crediting bureaus, you have three separate reports. 

The information contained in your credit report is as follows:

  • Personal Information: All of your basic information such as name, personal number, house address, and workplace, is mentioned here.
  • Credit Inquiries:  Every time someone accesses your credit report, a credit inquiry is generated. There can be hard inquiries, such as those that occur when you have applied for credit. However, soft inquiries are triggered when your information is being verified for various other purposes, like housing rental applications.
  • Credit accounts: Your credit accounts contain a history of your debt and all of the information related to it. This includes any outstanding balances you may have, your payment history, and your account opening and closing dates as well. 
  • Public information: If you have had any bankruptcies, this will also be included in your credit reports. 

How Can I Build My Credit?

Now that we’ve determined how a credit score can help establish your creditworthiness and allow lenders to give you credit on agreeable terms, let’s look at how you can build your credit and improve your credit score. There is no magic recipe for this. 

Building a good credit score requires patience and consistency. Small steps and plenty of monitoring can help you stay on top and eventually come out with an excellent credit score! Here are a few tips you can use to build up and improve your credit score: 

Know Your Credit Score

The first thing you should do when building your credit score is to ensure that you know your credit score and credit history well. Only once you’re aware of your current standing and at what points you may have faltered will you be able to improve your credit status. 

Keeping track of your credit score will also help keep you safe from identity theft or credit card fraud. You are entitled to get a credit report once a year for free from the three major credit bureaus in the United States. It is excellent to get these copies and go through them to ensure you are well aware of your credit status. 

Pay Off Debt As Soon As Possible

Pay down or pay off your debts every month. Your credit utilization and your overall debt affect your credit score. If you have high credit utilization for a long time, creditors may view this information negatively. 

Therefore, it is good practice to keep your credit card balance and usage in check whenever possible. If you pay off your debts in time, creditors will view this as financially responsible. Over time, low debts will naturally allow you to accumulate more wealth as well. 

Be Punctual with Payments 

A little punctuality can take you a long way. Being consistently tardy with the payment of bills and installments will undoubtedly affect your credit score negatively. 

If you feel that you cannot make a payment for the future installment, talk to your creditors about alternative options immediately. Doing so will not only help you avoid hefty penalties but will also help to maintain your credit score. 

Keep Old Accounts

Credit card history is an essential part of the credit report. Credit card accounts can prove to be a great way to show your good standing with credit, especially if you’ve been consistent with the payment of bills. 

So, if you have old credit card accounts with a good history that you have paid off, don’t hurry to close them. Pay the accounts in full every month and make small purchases on them occasionally. 

Build A Well-Established Emergency Fund

An emergency fund is a safety net in case things go south. Your emergency fund need not be extravagant, but it should have enough to save you from overly relying on debt in case of adverse events. 

This will help you avoid excessive credit utilization, which, in turn, is a good indicator of your credit status and behavior. Not to mention the peace of mind you get from knowing you’ve saved up for a rainy day. 

Instilling good financial habits into your life early on will help you build a good credit score over time and avoid unfavorable scenarios that negatively affect your credit status. 

What Is a Good Credit Score?

Your credit score may vary depending on what methodology lenders and credit issuers use to evaluate your credit report. However, in general, lenders consider a credit score of 720 or above as good. It will help you take out favorable loans at reasonable interest rates. 

As mentioned earlier, developing good financial habits and consistent with them will help improve your credit score. Once you’ve achieved your desired score, you must monitor and maintain it as much as possible. 

A good tip to ensure you are always on time with your payments is automating payments or budgeting and keeping track of all recurring payments before they’re due. 

What Does Good Credit Get Me?

There are numerous advantages of building and maintaining a good credit score. Here are some of the most important ones: 

  • Low-Interest Rates and Savings on Loans

Even small savings on big loans, often taken to finance large purchases, can translate into a difference of hundreds or thousands of dollars. 

When borrowing money from creditors, individuals with a good credit score are more likely to secure a loan with favorable terms, and low-interest rates. This is because creditors trust individuals with abundant creditworthiness more. 

  • More Access to Benefits and Better Terms

Individuals who have good credit scores will be given access to better services and most loans since creditors will be more willing to lend to them. Such individuals can compare price rates more effectively and secure good terms to finance big purchases with more ease. 

  • More Options for Housing 

Rental companies and landlords may consider a customer’s credit score before deciding to rent to them. The better your credit score, the more chances you have of gaining access to excellent rental properties. In some cases, landlords waive the security deposit for individuals with a good credit score. 

  • Better Credit Cards

A high credit score can also enable you to get you the best credit cards, ones that offer more incentives in the market. Credit issuers give the best credit cards customers with a higher score include added benefits such as cashback offers, gift hampers, significant discounts, and other benefits on the market. 

Other helpful credit card services offered to individuals with a good score include a 0% annual purchase rate and free balance transfers. All of these add up to give you a significant amount of savings. 

  • Discounts on Insurance

Although a low credit score will not disqualify you from getting insurance, it will keep you from gaining some of the benefits individuals with a good credit score may have. These include lower premiums and significant discounts. 

Top Misconceptions About Credit and Credit Scores

There are numerous myths regarding credit and credit scores. Most of these do individuals more harm than good and should be avoided at all costs. 

Paying Your Cell Phone Bill Helps to Build Your Credit

One of the most common myths about building your credit score is that paying your cell phone bill will help build your credit score. This is simply not true. Paying your cell phone bill does not affect your credit status. However, being frequently late for payments does harm your credit behavior. 

Your Credit Score Cannot Be Rebuilt

Easily improve your credit through good financial habits and avoiding debt. Paying your bills on time, getting credit counseling, etc. can all help to improve your credit score. 

Hard Inquiries Will Not Affect Your Credit Score

Hard inquiries have a temporary negative impact on your credit score. Therefore, it is more advisable to check your score through means that produce soft inquiries instead, such as credit reporting agencies. 

Carrying A Credit Card Balance Helps Improve Your Credit Status

False! This practice does the exact opposite of improving your credit status. It also means that you will be unnecessarily paying interest and owing money. Try to pay your bill in full and on time to improve and maintain your credit score. 

Laws and Rights

Certain laws and rights in the US protect the credit rights of consumers. Both borrowers and lenders must know of their rights before they engage in any transactions. 

The Consumer Credit Protection Act (CCPA) brought into effect in the 1960s separate laws for each aspect of personal credit. The five major parts of the CCPA are as follows: 

  • Truth in Lending Act: Ensuring creditors present honest and complete information
  • Fair Credit Reporting Act: Enables regulation of credit reports
  • Equal Credit Opportunity Act: Protects borrowers from discrimination 
  • Fair Debt Collection Practices Act: Establishes rules for debt collection
  • Electronic Fund Transfer Act: Protects consumers when they engage in electronic payments


Building a good credit score will invariably have a positive impact at some point in your life. Therefore, even if you don’t plan on making financial commitments, a good credit score can help you out in the future and is essential to maintain. After all, there are numerous benefits you can enjoy in the form of discounts and offers by merely having a high credit score. 

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