Credit impacts almost all aspects of your finances. It determines whether or not you can get a loan or a credit card. It also affects how much you are able to borrow and how much you’ll pay on what you’ve borrowed. Understanding how credit works will help you make smarter financial decisions.

How Credit Reports Work

People used to borrow money against collateral. That collateral acted as a security deposit. If the borrower defaulted on the loan, the lender sold the item kept as collateral and recovered their money. Because credit cards and some loans were offered without collateral, it became necessary to find another way to protect lenders. Enter the credit report system. The credit report system acts as a protective measure for banks and financial institutions that lend people money.

A credit report contains detailed information about your financial history including your credit inquiries, payment histories, balances, open loans, open revolving accounts, and closed accounts. It also features information regarding collections accounts and public records. These details give lenders a centralized source of information about potential borrowers. It allows them to get a more detailed look at the way prospective customers handle their finances which in turn helps lenders steer clear of lending to applicants who have a history of missed payments or those who are already overextended.

One detail a credit report doesn’t include is your credit score.

How Credit Scores Work

Where your credit report acts as a record of your credit history, your credit score is not included as part of the report. However, it is calculated based on the information contained in the report.

If your report contains positive information about on-time payments and low credit utilization, your credit score will be higher. Any adverse reports regarding late or missed payments or high credit utilization will hurt your score.

The reason your credit report and score matter so much is because it affects your borrowing ability. Lenders use your report and score to determine your eligibility for a loan or credit card. They also use it to set your interest rate. A solid credit report and good score will make it easier for you to get your loan approved and you’ll pay a lower interest rate. A low score will do the opposite.

How to Keep Your Credit in Good Standing

Here’s what you can do to keep your credit in good standing:

1. Make all loan and credit card payments by the due date. Do not carry outstanding balances or miss payment dates that will ding your score.
   
2. Try not to use all of your available credit just because you can. Low credit utilization will add valuable points to your credit score.
   
3. Keep old credit accounts open even if you’re not using them (provided that you’re not paying fees to keep it open). Old accounts add longevity to your credit history which helps boost your score.
   
4. Get a mix of revolving and installment credit. This shows that you can handle different types of credit, which is good for your score.
   
5. Don’t apply for too many new credit cards or loans at once. Every credit application triggers a hard inquiry which reduces your score by a few points. Too many inquiries at once can cause your score to plummet.
   

You are entitled to receive a free credit report from each credit bureau (TransUnion, Experian, and Equifax). Take time to look through it and report any inaccuracies that may be pulling your score down. Building strong credit takes time and commitment but it’s worth it for the many doors that it opens up to you.

Learn more about the three big credit bureaus.