How Credit Works: Understand The Credit History Reporting System

If you only have 15 seconds to learn how credit works, memorize the graphic above. It shows you the six key factors that make up your credit score, the three-digit number that summarizes the entire US credit reporting system and determines whether you can get approved for a loan or a credit card.

The keys to a good credit score are paying your bills on time, having a mix of accounts (credit cards and loans), and keeping these accounts in good standing for many years.

But, have you ever wondered: How does credit work? Why do you need a credit report, anyway?

The credit history reporting system helps banks avoid lending money to customers who are already overextended or who have a history of not paying their debts.

Less than 100 years ago, banking was a very personal experience. If you wanted to borrow money, you would need to walk into a local bank and personally convince a loan officer to give you the loan. You would have needed to show proof of employment and, quite possibly, personal references who could vouch for your character.

Back then, nearly all lending was secured, meaning you would need to put up collateral in order to take out the loan. The most common example of a secured loan is a home mortgage in which the bank takes an interest in the property.

Since then, the rise of credit cards as a convenient, electronic purchasing tool has made unsecured lending quite common. And although unsecured lending can be more profitable for banks, it’s also highly risky because there’s no collateral for the bank to repossess if the debtor doesn’t pay back the loan.

As a result, the credit report system was created to give banks a centralized source of information about potential borrowers.

» MORE: Get free credit scores and monitor your credit health.

By the late 1950s and early 1960s, banks began collaborating to share customer credit data including account balances and payment histories.

These early “credit bureaus” were small and limited to individual communities. By 1970, however, a few large companies emerged as leaders in credit reporting. These companies would become the three credit bureaus we know today: TransUnion, Experian, and Equifax.

In 1970, Congress first passed the Fair Credit Reporting Act (FCRA) to regulate how credit reporting companies handled consumers’ personal information, but credit reporting was still primitive compared to the comprehensive reports we have today. By the early 1980s, credit bureaus began to electronically store the detailed personal information (Social Security numbers, addresses, dates of birth) as well as the loan, inquiry, and payment data that still comprise our credit reports today.

Your credit report contains information that identifies you, such as your name, address, and Social Security number and information about your borrowing activity, such as loan applications, balances, and payment histories.

In addition to your name, Social Security number, and date of birth, your report may also contain previous addresses and employment information. Despite all of this unique information, credit report mix-ups are still quite common, especially if you have a common last name like Jones or Brown.

The bulk of your credit report contains detailed information about recent activity on your financial accounts. This includes:

• Credit inquiries: Any time you apply for credit—whether or not you are approved.
• Open loans: Data will include the bank, the loan amount, the date you opened the loan, your monthly payment amount, and your payment history.
• Open revolving accounts: These are your credit cards. Data includes the bank, your credit limit, the date you opened the account, your payment history, and the balance on the account as of your last statement date.
• Closed accounts: Accounts will remain on your report even after they are closed for up to seven years.
• Collections accounts: In the event you have a bill sold to collections, this account will appear on your credit report. This can happen even if the original debt wasn’t included on your credit report, such as a medical bill.
• Public records: These include tax liens, court judgments, and bankruptcy filings.
• Comments: Credit bureaus give you the ability to add comments to your credit report to explain records. Creditors can also add comments.

One thing your credit report does not contain is your credit score. The credit report is designed to track your credit history. The score is issued based on the information.

Today, companies use the data in your credit report to create credit scores, which most lenders will use in their underwriting as an alternative to manually reading your credit file.

That said, you can expect an underwriter to look more closely at your credit report when you’re applying for a larger loan—such as a mortgage—or in cases where your credit score is “on the fence.”

In addition to approving your loan, your credit may determine how much you’ll pay for the credit. The higher your credit score is, the less interest bank will charge you for the loan.

Who cares? Well, you should if you care about saving money. For example, the difference in total interest payments on a $250,000, 30-year mortgage between a 5% interest rate and 8% interest rate is about $179,000. That is the cost of less-than-perfect credit.

Sometimes, companies will use your credit score for other decisions, too.

For example, you might be asked to submit to a credit check when renting an apartment or applying for a job that involves financial responsibility. (Some employers have used credit checks more broadly in their hiring process. I think that practice has dubious value, but it’s yet another reason to take care of your credit.)

Finally, insurance companies often use a specific version of your credit score in determining how much you’ll pay for car insurance.

A credit score is a three-digit number derived from the data in your credit report that indicates how likely you are to repay a loan on time in relation to other borrowers.

Different companies produce different credit scores under brand names like FICO Score and VantageScore.

Each of these companies may have several different versions of their score for different end uses (for example, one for mortgage lenders, one for credit card banks, another for car insurance companies).

Finally, each of these credit scores may differ depending on which of your three credit reports was used to pull the data. There are three credit bureaus: TransUnion, Experian, and Equifax. Although most of your credit report will be the same across all three, there can be differences.

FICO Scores, which are used by 90% of lenders, are a highly trusted measure of whether a loan will be paid on time. Other types of scores simply use payment history to calculate your score, whereas FICO’s algorithms calculate your creditworthiness based on the information found in your credit report.

In general, however, all credit scores fall somewhere on a range between 350 and 900. The higher the score, the better your payment history and creditworthiness. A lower score means banks will consider you a higher risk customer.

Although it depends on which score you’re looking at, you can be confident that a score of 720 is “good” on most scales, while a score of 800 is “very good” on most scales.

If you have a score of at least 700, you’ll have the best chance of getting approved for the best credit card offers, auto loan rates, and mortgage rates.

Scores in the high 600s aren’t necessarily bad, but they won’t qualify you for all loans or the best rates. With a sub-700 credit score, you could also still be declined for many of the best credit card offers.

Finally, it’s important to note that once your credit score approaches the high 700s to low 800s, any further increases won’t do much for you…banks will already give you the best rates. (It’s like if a prof awards an A+ to numerical grades of 97-100, once you hit 97 there’s no additional benefit to getting a 98 or 99, etc.)

There are three big components to a good credit score: establishing a healthy mix of loans and revolving accounts over time, paying bills on time (every time), and avoiding high levels of debt.

How long does it take to build a good credit score?

The first step—building credit by establishing a healthy mix of loans and revolving accounts—is often the trickiest, because it’s a catch-22: You need to get credit before you have a credit history, but it’s difficult to get credit before you have a credit history!

There are several ways to establish credit for the first time, but it’s arguably easier to do when you’re young and either in college or still dependent on your parents. For example, you can:

• Ask a parent to make you an authorized user on one of their credit cards.
• Take out a federal student loan, which generally does not require a credit check.
• Take out a loan with a cosigner.
• Get a secured credit card, which works like a prepaid debit card except it builds credit.
• Get a credit builder loan.
• Use a free service like Experian Boost®, which allows you to benefit from on-time payments that otherwise wouldn’t be included in your credit profile.

Once you have one open account, it becomes easier to get additional accounts after about six months. Over time, you’ll get the best credit score when you have at least one or two credit cards and one or two loans (like student or auto loans). That said, having more accounts is not necessarily better.

Finally, a key part of credit scoring is time. It typically takes three years of responsible credit use to have an average credit score in the mid to high 600s and up to seven years to develop a very good credit score of 700 or more.

Why is paying your bills on time so important?

Your payment history accounts for approximately 35% of your credit score, more than any other factor. Making consistent on-time payments is the number one thing you can do to build a good credit score.

Not surprisingly, nothing will wreck your credit score faster than failing to pay these bills on time. The longer you take to pay them (and the more often you’re late), the lower your credit score will fall.

An example: I’ve had fairly good credit all my life, but once many years ago I screwed up and paid two bills late (just by a few days). My credit scores fell by an average of 60 points and it took two years to fully recover.

How does debt affect your credit score?

Too much debt is bad for your finances and it’s bad for your credit score, too. Your overall debt level accounts for 30% of your credit score.

Credit-card utilization (or how much of a balance you carry in relation to your credit limit) affects your credit score. The higher your combined balances in relation to your combined credit limits, the more your credit score will suffer. For the best credit score, you want to keep this “utilization ratio” as low as possible.

Keep in mind that even if you pay your balance in full every month, your credit report reflects your card balance on the last day of your billing cycle. If you frequently use most of your available credit each month, your credit score will suffer even though you’re paying the balance in full every time. You can avoid this by paying off most of your balance on the day before your credit card billing statement closes. Your credit report will show a $0 balance—or close to it.

Other factors affecting your credit score

Other factors that affect your credit score include the average age of your credit accounts (credit file age), account diversity, recent credit inquiries, and public records. With the exception of public records, each of these factors make up about 10 to 15% of your credit score.

The longer you have had credit accounts open, the better. If you don’t have to cancel an old, unused credit card, don’t.

Your credit score won’t be as good as it could be if you only have credit cards or only have loans.

Finally, try to limit credit applications to no more than two every six months. Checking your own credit score is known as a “soft inquiry” and does not count toward this limit.

Too many credit applications in a short period of time can cause your score to go down because it looks like your desperate for credit. There’s an exception, however, for credit inquires of the same nature that indicate you’re rate shopping. If these inquiries are within a month or so of each other, they will generally only be counted as one inquiry.

Public records are one thing you definitely do not want on your credit report, because it usually means that someone has taken you to court over a debt. Many, like tax liens or credit judgments, can drag your score down for years.

A bankruptcy filing can be the kiss of death to your credit score, at least for a number of years. Your credit score can recover from bankruptcy, but it will take between seven and 10 years. Like building credit from scratch, the hardest part will be getting your first one or two credit accounts after bankruptcy. With few exceptions, this usually means starting with a secured credit card.

The same way you build good credit! By paying your bills on time and staying out (or getting out) of debt.

Unless you’ve been the victim of identity theft or otherwise have errors on your credit report, the only way to “repair” your credit is to pay your bills, pay down debt over time, and limit applying for new credit.

Expect it to take between one to two years of responsible credit management to make an impact on a troubled credit score (longer in the case of bankruptcy), and be wary of anybody who tries to sell you shortcuts to a better credit score.

For more, read our article on how to repair your credit on your own.

These days it’s easy to track your credit score with any number of free credit reports and scores. Many credit cards even provide your FICO Score on monthly statements, too.

You can sign up for a monthly credit monitoring service. There are both free and paid credit tracking services. The free services will typically give you one version of your credit score and a limited look at your credit report. Paid services are more likely to give you access to all of your credit scores and/or complete access to your credit report.

In the United States, the best way to review all three of your credit reports for free is to go to annualcreditreport.com. The US government mandates that all consumers can receive each of their three credit scores from this site once a year for free. While checking your complete reports at least once a year is the bare minimum, I would also recommend using another free credit monitoring service to routinely monitor your score and get alerted to any problems.

It’s important to re-emphasize that your credit report will not contain your credit score. For that, you can sign up for a service like myFICO if you don’t receive the information from your lending institution or credit card provider. Make sure you’re keeping an eye on your FICO score, as it’s the one most likely to be used when you apply for credit in the future.

Credit monitoring is also really helpful if you’re getting ready to apply for a mortgage or you suspect you’re susceptible to someone else trying to use your credit information.