Whenever you open a credit card or apply for a loan, credit bureaus collect information about your usage. That information appears on your credit report and is used to calculate a numeric credit score. Your payment history, credit utilization, mix of credit accounts, length of your credit history, applications for new credit all affect your credit and your ability to qualify for financing in the future.
Credit affects many parts of your life, both as a consumer and as a small business owner. Whether you apply for a business loan, make a major purchase, open a cell phone plan, or turn on utilities like water and electricity for your home, your personal credit comes into play. And using credit wisely is essential to having continued access to it in the future.
Unfortunately, since personal finance isn’t taught at most high schools or colleges, the majority of consumers learn the answer to “How does credit work?” from their parents or through trial and error—often only after facing the tough experience of being held back from their dreams and goals because of credit challenges.
Read on to learn all about how credit works, so you can be a smarter consumer and business owner. It’s not just about achieving the perfect credit score. Sure, that’s nice. But it’s more important to understand how different actions affect your credit, so you can better prepare for your business’s financial future.
How Does Credit Work? Personal Credit Basics
How does credit work? If you’re brand new to the idea of credit, let’s start with the very basics. Consumer credit comes into play whenever you borrow money as an individual. The person borrowing is responsible for making payments—and the information about amounts borrowed, as well as the schedule and size of repayments is recorded on that person’s individual credit file.
Consumer debts like car loans, mortgages, and credit cards are the most common types of credit accounts, and creditors in these categories report both positive and negative payment histories to credit bureaus. But those aren’t the only forms of credit that exist.
If you rent an apartment, have a cell phone, or use utilities for your home, those can all be considered credit accounts as well under the latest credit scoring models—the company or creditor in question (think your property management or utilities company) offers you a service and expects you to remit payment after the fact.
You might be wondering where business loans fit in to all this. Even when you borrow money for your business, your personal credit score is very relevant. The reason is that small businesses have high failure rates, so lenders use personal credit score as a proxy to evaluate whether you’re likely to pay back a business loan on time.
how does credit work
Types of Credit
In addition to the different ways that creditors report a borrower’s payment history, there are also two main types of credit accounts, which work a little bit differently in terms of how they process payments and how they’re reported. These are installment credit accounts and revolving credit accounts. Let’s take a closer look at each.
Installment Credit
Imagine that you take out a five-year car loan with 60 monthly payments. When you first open the loan and make your first few payments, your utilization ratio (or your ratio of amount owed to amount paid) will be very high. Closer to the end of the five years, on the other hand, your utilization rate will be much lower because you’ll have made the majority of payments.
A traditional term business loan is a prime example of an installment credit account. It’s closed-ended with specific payment terms, a clearly outlined repayment schedule, and an explicit end date. The utilization ratio on an installment credit contract always decreases incrementally over the life of the loan.
Other examples of installment credit account include car loans, student loans, mortgages, and personal loans.
Revolving Credit
Accounts labeled as revolving credit are probably the ones that you already associate most closely with credit reporting or borrowing funds. A common example of a revolving credit account is a credit card, which offers a set credit limit, minimum monthly payments, and charges interest on any balances carried from month to month.
Another example is a business line of credit. As with a credit card, a line of credit has a fixed credit limit. The lender sets a specific repayment schedule, and when you’ve paid back what you borrowed in full, your available credit goes back up.
Revolving credit offers borrowers a lot of flexibility to spend money now but pay for the purchase when they have the cash available. Of course, that convenience tends to come with a hefty monthly fee in the form of high interest rates.
Types of Borrowers
Not everyone who opens a revolving credit account actually revolves the balance on that account. Creditors typically classify borrowers as either transactors or revolvers, depending on how they go about using their revolving credit lines. This classification has important consequences for your credit.
Transactors
In an ideal scenario, you’d approach every credit relationship with the goal of being a transactor. You have a credit limit on your credit card or line of credit, you spend a certain portion of that limit, and you pay the balance in full each and every month.
The greatest benefit to being a transactor is that, when it comes to credit cards or lines of credit, you never have to worry about hefty interest payments. Because you aren’t carrying a balance month to month, interest charges will never kick in. And equally importantly, operating as a transactor in your credit relationships almost guarantees a positive credit history over time.
Revolvers
Let’s say you have a credit card with a $10,000 limit. If you spend $5,000 toward that limit in one month but only pay back $1,000 of that amount, you’ll be revolving or carrying a balance of $4,000 on that card.
Borrowers who operate as revolvers typically have little, if any, margin in their personal finances. It’s easy to see how—if your spending continues to outpace your payments as in the example above—your levels of debt could skyrocket quickly.
In these scenarios, it only takes one unexpected expense or loss of income to turn a revolving borrower into a delinquent payer.
Sample Credit Report
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