Credit cards are powerful tools that can help you build excellent credit—but they can also sink your finances. Money Girl answers a listener question about healthy ways to use credit cards. You'll learn how the credit system works, tips to manage cards, and how credit affects your entire financial life.
Rebecca from Brooklyn says, “I really do enjoy the Money Girl podcast and listen as much as I can. As a 24-year-old, I'm new at my job and at managing money and I think it can be scary. But your podcast has helped ease my confusion and anxiety. My question is about the good, the bad, and the ugly of using credit cards. How do credit cards help you build credit and what are some healthy ways to manage cards and credit?”
Thanks for your question, Rebecca. I'll answer it by starting with an overview of how the credit scoring system works, to make sure you understand the rules of the credit game. Then I’ll explain how to use this information to build and maintain excellent credit for life.
How Do You Build Credit?
Many people have no idea how the credit system works. They may not care until they need a credit card or want to finance a big purchase, such as a car or home, and get denied.
Unfortunately, most of us are never taught about credit in high school or college. So, it’s no wonder that many people struggle to improve their credit. If you don’t understand all the components that factor into your scores, your credit rights, and various ways to build credit, you’re at a serious disadvantage.
Here’s an overview: Information about you gets reported to one or more credit bureaus that maintain the data in your file, known as your credit report. Then companies who want to access your credit report pay the bureaus for your information.
Credit bureaus don’t make lending decisions; they maintain your data. But credit reports can be huge, so companies want a quick way to evaluate you. That’s why credit scores were designed--they’re a snapshot of your current credit situation.
Understanding Credit Scores
Credit scores are calculated from the information in your credit reports. And there are hundreds of different credit-scoring models in use. So, you actually have many credit scores, not just one.
Some scores are proprietary systems that lenders create for themselves, and others are well-known, such as the FICO, which stands for the Fair Isaac Company, which created it. But even FICO offers dozens of different scores. There are newer versions and some just for specific types of products, such as mortgages, credit cards, and auto insurance.
FICO also markets different scores that are custom-made for each of the nationwide credit bureaus. They tweak the underlying algorithms for different scores and roll them out periodically.
The FICO score ranges from 300 to 850. More than half the U.S. population has a FICO score of 700 or higher. Many lenders use a FICO score of 740 as the cutoff for having excellent credit and giving you their best rates and terms.
TransUnion's TransRisk score ranges from 300 to 850 and the Equifax Credit Score ranges from 280 to 850. Experian has a score that ranges from 360 to 840. And there’s a score that the credit bureaus created together, called VantageScore, which ranges from 501 to 990.
So, you see that there are similarities, but no two credit scores are the same. Each scoring model evaluates you a little differently and gives different “grades.”
Each scoring model evaluates you a little differently and gives different “grades.”
No matter which type or brand of credit score that a company or individual uses to evaluate you, scores are simply a snapshot of your credit information. As new information is added to your credit reports and old information is deleted, your scores are constantly changing. The higher your score, the more trustworthy and responsible you appear.
I don’t want you to worry about seeing or keeping track of every possible credit score because that would be impossible to do, and it really doesn’t matter. Instead of getting caught up in the nuances of different scoring models, focus on the big picture.
By concentrating on what’s in your control and improving your financial behavior so more positive information gets added to your credit reports, you’ll be in good shape.
Another important concept to understand about the credit system is that every person has his or her own credit reports and credit scores. In the U.S., your credit data is compiled and tracked by your Social Security number. That means any resident who qualifies for a Social Security number can build a credit file in the U.S.
Your credit information is never merged with someone else’s, even when you’re married. Spouses each have individual credit reports and scores, which is why it’s so important to build your own credit history. If you co-sign a loan or a credit card application with someone else, both of your credit scores are evaluated in the approval process.
Because credit scores are based on your credit reports, it’s critical to know what’s in those reports.
To sum up, a credit score is simply a number that represents a current evaluation of the data in your credit report. Because credit scores are based on your credit reports, it’s critical to know what’s in those reports.
Here are several free sites where you can review your credit reports for free: