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How Does Credit Work and Understanding Credit Scores

January 31, 2024
Sam Helmy
What goes into a credit score, and what is good vs bad credit? Read on to find out the different factors affecting credit and what you can do to help improve and build up your credit score.

Credit and credit scores are among the most misunderstood things in the world. Very few people truly understand the impact of good and bad credit, how these work, and how you can improve your credit.

Considering how important a role credit and credit cards play in any travel rewards strategy, it is imperative that any fan fully understand how everything works. The main reason for this is that to be approved for some of the best travel rewards cards out there; you need to have excellent credit.

Understanding credit is key to successfully managing your credit cards and their benefits.

Developing excellent credit takes time and patience, as well as a solid understanding of the rules and what you need to build it.

No Debt is Bad for Your Credit Score

Often, you will hear someone say, “I have no debt, so I must have excellent Credit.” Sadly, nothing is further from the truth, and more often than not, having no debt means you have a low to poor credit score.

The fundamental issue is that credit scores allow lenders to judge your creditworthiness and how likely you are to repay your debt. This is a judgment of your behavior, so patterns are needed to make it. The FBI Behavioral Science Unit (the guys who catch serial killers) often say the best predictor of future behavior is past behavior, and the same is true for credit.

If you have never had any credits or debts, how will the lenders know how good you are at managing these debts? They have seen no track record of your spending and repayment patterns. Therefore, they cannot say that you will be a good risk. In fact, being careful, more often than not, they will take the safe bet and not extend you some credit. If someone never had credit but all of a sudden needs some now, that is a sign of financial distress, making them a gamble not worth taking.

Some Delta Credit Cards provide lots of excellent benefits when flying with the airline.
Some Delta Credit Cards provide lots of excellent benefits when flying with the airline.

Logically, you would be thinking, how do I get started building a credit history if I can’t get approved due to not having a history? The answer is pretty simple: not all issuers will deny you credit. Some with a bigger risk appetite will happily extend first-timers’ credit. However, in many instances, you will find that your line of credit is very low, and the interest you are paying is relatively high. That way, the risk pays for itself.

The Two Credit Score Models: FICO Vs Vantage

Currently, there are two credit scoring models used by different institutions.

Vantage Credit Score Models

This Vantage model of credit scores is the newer of the two models and came into being in 2006. It was created and is being used by the main credit bureaus in the United States, Equifax, Experian, and Transunion. Vantage scores are typically in the 300 to 850 range. Very poor scores range from 300 to 499, while an excellent credit score ranges from 780 to 850.

FICO Credit Score Models

The FICO credit score is the oldest credit score around. It takes information from each of the three credit bureaus mentioned above and generates a score for each one based on the information provided. Banks and financial institutions use this and other information to determine whether to approve you for a line of credit.  A very poor FICO score is in the 300 to 580 range, while an excellent score is in the 800 to 850 range.

The Air Canada credit card lets users access Maple Leaf lounges in some situations.
The Air Canada credit card lets users access Maple Leaf lounges in some situations.

While the math behind them is slightly different, they are fundamentally designed to assess the same thing: how much of a risk are you?

Factors Affecting Your Credit Score

Multiple factors affect your credit score, and it is not solely a question of income. Since the relationship between the different aspects of finance needs to be taken into account.

For instance, someone with a $1,000,000 income but a total debt of over $5,000,000 is in much worse shape than someone with a $100,000 annual income and no debt at all.

What Does Your Payment History Look Like

By far, the biggest factor determining your credit score is your payment history. Paying your bill or meeting the minimum payment every single month after month shows lenders that you are reliable and managing to meet your financial obligations.

Credit Card payment can be used to generate a huge number of points and miles

Remember that while paying your bills regularly is an excellent way to keep and grow your credit, you have to show that you are doing more than meeting the minimum. If you meet the minimum amount but the total amount you owe grows every month, that is a big red flag for lenders.

That pattern looks like someone not managing their credit well and living beyond their means. Eventually, the minimum payment will get so large they will not be able to afford it, and disaster will strike. It is always a good idea to pay a large chunk of what you owe every so often to bring your credit utilization (more about that later) back to acceptable levels.

Understanding Credit Utilization

Credit utilization is the ratio between your used and total credit lines. For instance, assuming you only have credit cards. Adding up all your credit limits, let us assume it Is $10,000; now, looking at your outstanding balances, let’s assume you have $5,000 of bills. That means you are using half of your available credit limit. In other words, your credit utilization is 50%.

So now, the question is what is good and what is bad credit utilization. This can be very opaque since different models and institutions will look at this differently. As a rule of thumb, anything over 50-60% is considered bad, especially for a continuous length of time.

However, as mentioned above, a credit utilization ratio of zero is no good either. So, what are you looking for? As a rule, try and aim to keep your credit utilization between 10-30% and no more. When it climbs closer to the top band, pay some off and bring it down to close to the lower band. Manage your finances this way and keep your credit utilization ratio in check, and you will see your credit score grow and improve.

The Age of You Credit History Affects Your Credit Score

The longer your track record of successfully managing your credit, the better your credit score will be. This shows that you can manage your finances over time despite the variables that life will throw your way.  The longer your history, the better.

New Credit Applications (successful or not)

Interestingly, every time you apply for new credit, your score takes a little hit whether you are successful or not. As a rule, the models look at new credit applications like a change, and the models do not like change since they can be unpredictable. Some credit issuers will even automatically disapprove you if you have had too many applications in recent months, regardless of your score. Therefore, if you want to apply for various lines of credit, it is best to space out your applications over a period of time.

Your Existing Credit Line Mix

Credit scores also looks at the mix or blend of your line of credit. Having multiple lines over various items, like a mortgage, personal loans, credit cards, and more, shows that you can manage different types of credit well. It also shows prospective lenders that you have a good overall grip on your finances and are capable of dealing with different things. As a rule, the wider your mix, the better your score. However, too wide a mix may show that you are living beyond your means and are incapable of sustaining your lifestyle in the long run.

Points earned from spending on your credit cards can be used towards meeting your next travel goals

Paying Everything Off Every Month Can Be a Negative

One of the more interesting aspects of managing credit and boosting your attractiveness in the eyes of lenders is paying off your credit every month. Some people treat their credit cards like charge cards and pay it off entirely every month. Counterintuitively, this can mean that lenders take a negative view of your worthiness.

If you are wondering why? The answer is simple: Interest! Put yourself in the financial institution’s shoes. More often than not, if you pay everything off every month, they earn very little interest on the line of credit they have extended to you. Financial institutions want you to carry a small amount of manageable debt that you pay interest on. That makes you the most attractive customer in the world since, over the long term, you are a profit center for the institution.

Final Thoughts

Understanding how credit and credit scores work is key to building a strong credit history and having a high credit score. The good news is that it is relatively easy to understand what you need to do to have a bulletproof credit score. The downside is that building a good credit score takes time and patience. Sadly, there are no shortcuts to having excellent credit.