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Learning How Credit Works: Managing Your Spending

Learning How Credit Works: Managing Your Spending

Many Americans have a working knowledge of how credit works and yet still continue making costly mistakes that impact creditworthiness, interest rates on financing, and overall economic stability. Take time to learn how credit influences your life and the decisions you could make to improve your credit score. It can be surprising how a few simple changes can dramatically change your credit score for the better.

What Is A Credit Score?

Various credit bureaus track credit-related information for all U.S. adults. These bureaus use various formulas to calculate a person’s credit rating, a numerical value of his or her creditworthiness.

  • A bad credit score is any credit score under 640.
  • Fair credit scores hover in the 640 to 700 range.
  • Any credit score between 700 and 750 qualifies as a good score.
  • Excellent credit includes credit ratings of 750 to 850.

This scale may seem straightforward at first, but countless factors go into an individual’s credit scores. It is very important for anyone who seeks any type of financing or credit line to know the terms and conditions and how interest will apply to avoid significant credit-related problems in the future. Defaulting on loans or failure to pay your bills on time can negatively impact your credit score for years to come.

Things That Impact Your Credit Score

If you intend to apply for a credit card, a small business loan, or financing for a home or vehicle purchase, one of the first things a creditor will look at is your debt-to-income ratio. This ratio basically defines your financial flexibility. If you have a low debt-to-income ratio, this means you make more than enough money to pay your debts based on your average income. A high debt-to-income ratio means that you likely have very little income leftover after paying your bills each month. If you have a high debt-to-income ratio, a creditor will likely feel less inclined to extend you credit since there is a lower chance you will pay your bills on time and in full.

Credit bureaus also take your bill paying habits into account when assigning your credit score. Some of the various factors that can influence your credit score include:

  • Failure to pay a bill on time, or multiple late payments on a credit line. Consistent timely payments can comprise as much as 35% of your overall credit score.
  • Defaulting on a loan or failing to pay back a loan as required by the loan contract.
  • Attempting to defraud a creditor.
  • Changing jobs frequently.
  • Frequent or too many credit requests in a short timespan. This could indicate to the credit bureau that you are attempting to open several lines of credit at once.
  • Periods of unemployment.
  • Private and government liens. Some liens may remain on your credit report for up to ten years.
  • Unpaid utility bills.
  • Ignoring potential inaccuracies or identity theft. It is essential to carefully monitor your credit lines and address fraudulent or suspicious activity as quickly as possible.

Ultimately, whenever you take on any type of loan or debt it is essential to pay it off as soon as possible while abiding by the terms of the contract. A lender will stipulate when and how payments are due, how your payments apply to your principal and your interest, and your interest rates.

Working Your Way Out Of Bad Credit

If you want to increase your credit score, your first step is to prioritize your spending in a way that reduces your debt. Paying down the balances on your open lines of credit and active loans is the best way to increase your credit score, but this takes time. If you are trying to recover your credit score or are just starting to build credit, a few tips can help you avoid astronomical interest rates and set you up for a better credit score in the long run. Some of the things you can try to boost your credit score more quickly include:

  • Paying off liens as soon as possible. Liens are one of the most detrimental factors in your credit score, so work toward paying them off as quickly as you can.
  • Paying off higher-interest debts first. The higher the interest rate on a line of credit, the more you will pay overall to settle the debt. Target your highest interest rate loans and lines of credit and work on paying those off before your lower-interest rate debts. Of course, you want to keep making payments on all your debts, but prioritizing extra money toward your higher-interest loans will benefit you more in the long run.
  • Limit frivolous spending. Eating takeout every day for lunch at work is more expensive than many people realize. You could very likely buy groceries and cook your own meals for a fraction of what you spend on takeout. The money saved could make a major difference in your outstanding balances.
  • Limit the number of credit inquiries you request in a short time. If you are shopping for credit cards, research available offers on your own and wait to request an inquiry until you are sure the credit line meets your needs and budget.
  • Keep outstanding balances as low as possible. If you need credit for a sudden and unexpected expense this could be difficult, but ultimately you should strive to keep all outstanding balances as low as possible.
  • Pay more than the minimum payment. If your credit card requires a $50 minimum payment, remember that this amount will not entirely go toward paying down the principal on the account, but also the interest. However, whatever you pay over the minimum payment amount usually goes toward the principal. For example, on the credit card with the $50 minimum payment, paying $60 would ensure the extra ten dollars goes toward the principal, which in turn lowers the overall interest you will pay on the account.
  • Set up payment reminders. Most Americans pay their bills online now thanks to the ease and convenience of online bill paying software and most creditors having proprietary apps. Find out if your creditor offers any type of app or payment reminder program you can use to build a solid payment schedule for yourself.

Bad credit can happen to anyone for various reasons, so use these tips as a starting point and develop a repayment plan that helps you tackle your debts in the most beneficial way possible to escape debt and increase your credit score.