How credit and credit scores work
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If you’re a regular reader of TPG U.K. you’ll know we talk about how points and miles can help you maximise your travel. One of the best ways to earn them quickly and most efficiently is through a credit card that earns points and miles.
But before delving into the world of miles and points, let’s take a step back and look at the basics of credit and credit scores.
What is credit?
In simple terms, credit is the ability to obtain a product or service with the understanding that you’ll pay for it later. In the world of credit cards, a card issuer will extend credit to you by way of issuing a credit card, which you can use to pay for goods and services and then repay the card issuer for issuing this credit to you at a later date. You will have entered into a legal agreement with the credit provider as part of the application process for the card. The agreement dictates the terms that the issuer will provide the credit to you and how and when you will repay the credit, including your obligations and the credit issuer’s rights should you breach the terms of the agreement.
The credit provider takes on a risk that you may not repay it on time and charges you interest the longer you take to repay it. The card issuer will provide a statement period to you each month. If this period follows a calendar month, then taking the month of March as an example, you can use the card to pay for goods and services during the month of March and then at some time during April (usually two weeks after the end of the statement period, which in this case, would be mid-April), the balance will become payable. You will be required to pay at least a minimum repayment (usually 1%-3%), and will then be charged interest on any amounts you do not pay back until you have paid the balance in full.
When you apply for the card and the credit is issued to you, there will usually be a credit limit on your card based on your credit provider’s understanding of your financial situation and ability to repay the credit it extends to you. If you have a high income, high credit score and no history of bad credit (more on that below), you may be provided with a high limit, whereas if you have a low income, low credit score and have had issues with credit in the past, you may only be given a low limit.
When you have used credit provided to you by a credit provider, you are indebted to them to pay it back, which is where the idea of debt comes from. How you repay this debt to the credit provider is called “servicing” the debt — whether you pay on time or whether you fail to make the required payments at all indicates poor servicing of the debt. Where you service the debt responsibly, making all required payments on time, the credit provider may be willing to give you more credit because of how well you have shown you can service the debt.
If you apply for a car loan or a home loan/mortgage, the principles are the same. The credit provider will issue you with a level of credit they believe you can repay and agree to how, when and what you will do to repay/service the debt issued to you.
What is the difference between credit, debit and charge cards?
- Credit cards, as described above, usually have a credit limit, and once you have spent up to the credit limit, you cannot use any more credit until you have paid down the balance to below the credit limit. You can usually choose to pay the entire balance every statement period, just the minimum repayment or an amount in between of your choosing.
- Charge cards usually do not have a credit limit, so you have virtually unlimited credit provided to you. In exchange for the credit provider taking on this much risk, the entire balance will be due each statement period, without the option for you to choose to repay just the minimum owing, or a custom amount.
- Debit cards are where you use your own money from a current account to spend. There are no rules around credit limits or minimum repayments. The money is deducted immediately from your own account, so you can spend as much of it as you want, as it is your own money and not credit provided to you by a credit provider. Unlike credit and charge cards, debit cards usually do not earn points, miles or other rewards.
What is a credit score?
Credit providers will consider various aspects of your personal and financial situation in assessing whether they wish to provide credit to you, and on what terms. The provider will check factors like your age (to ensure you are an adult), your address to ensure you actually reside in the U.K. and will also look at your credit history. If it has provided credit to you before, it will review how you serviced the debt in the past. It will also check how you have serviced debt to other credit providers, whether it has provided you with credit in the past or not.
The way credit providers in the U.K., such as American Express U.K. do this is by checking your credit score with third-party credit agencies. Credit providers (not just of credit cards) report regularly to credit agencies on how individuals service debt, which then create credit scores based on the individual’s debt-servicing history, which credit providers can then check to determine an individual’s credit worthiness (especially if the credit provider has not provided credit to that individual before).
In the U.K., these credit agencies are Equifax, Experian and TransUnion (formerly CallCredit). Each credit agency uses the information on the individual’s debt-servicing history (reported by credit providers) to give a three-digit score to each individual. Experian’s score is between 0 – 999, TransUnions’ is 0 – 710 and Equifax is between 0 – 700. The higher your number, the better your credit worthiness is, the better your score is and the higher likelihood a credit provider will provide credit to you.
What makes this confusing is that each credit provider uses different numbers for different levels of credit score:
|Very Poor||0 – 279||0 – 560||0 – 550|
|Poor||280 – 379||561 – 720||551 – 565|
|Fair||380 – 419||721 – 880||566 – 603|
|Good||420 – 465||881 – 960||604 – 627|
|Excellent||466 – 700||961 – 999||628 – 710|
So you could have an excellent score with all three providers, but your actual number could be 480 with Equifax but 990 with Experian.
You can view your score for free through these providers if you are curious as to what your score is. My Experian score is currently 938 out of a possible 999, which is rated as Good
What impacts your credit score?
Good debt-servicing like paying at least the minimum balance on time, every time and having no court judgements or default notices against you will help your credit score. The opposite will make your credit score drop.
Also, if you apply for credit too often, such as applying for a credit card every month, this will make your score decrease as it suggests to credit agencies and providers that you are desperate for credit, which in turn could lead to difficulties in responsibly servicing it.
Should I care about my credit score?
Yes. Credit scores are a very important personal record that credit providers will use to make important financial decisions about you. You should check your score to make sure there’s nothing incorrect on your file. Just like if you had an incorrect criminal record, you don’t want an incorrect credit score.
If you’ve never had any default notices issued to you by a credit provider in the past yet your credit report (which accompanies your credit score) shows defaults, contact the credit agency to have anything incorrect removed.
If there is something on there that isn’t favourable but it is true, you will have to leave it on there. Agencies will only remove factual errors, not something that actually happened that you would just prefer didn’t.
If you don’t have a perfect score, it doesn’t mean you have a bad score and therefore will not be approved for credit. It just means you may, for example, not obtain as much credit as someone with a higher credit limit.
Credit scores and debt servicing aren’t the most exciting way to maximise your travel, but they are very important. If you are considering applying for credit, like a rewards credit card, it is critical you understand the responsibility you are taking on and how the credit provider will determine if, how much and on what terms they will provide credit to you and how you must service that debt responsibly.
Featured image by Getty Images.
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