Credit Cards 101: A Beginner's Guide to Credit Scores and Building Credit

When you were a kid, you probably thought adulthood meant that you would get to be the one who wielded the free money cards that allowed you to buy whatever you wanted. Sadly, you became an adult and realized they aren't actually "free money" cards, but rather tricky little pieces of plastic that can be a real headache when used the wrong way. Credit cards can be fantastic, offering consumers perks and a way to build their credit score when used responsibly. When used irresponsibly, however, they can result in years of dealing with collections companies and ruining your ability to borrow in the future. Thankfully, no matter where you are on your credit journey, you are always empowered to improve your credit literacy.

Why credit literacy is your most valuable financial skill today

Many people believe that if they're not utilizing credit cards or actively looking to take out a line of credit, their credit score doesn't matter. While there might have been a time when that was true, in today's world, your credit history affects your life well beyond your ability to borrow money. Oftentimes employers and landlords factor in your credit report when conducting a background check. While they might not care about the actual number, multiple liens, bankruptcies, or a chronic inability to repay debts can be a cause for concern.

This doesn't mean that you should panic if your current credit history is a bit less than desirable. Don’t think of improving your financial literacy as a burden or something you should fear, but rather an opportunity to learn and grow.

What is a credit score and how does it work?

A credit score is all of your credit history condensed into one succinct number. This number, which can be anywhere from 300 to 850, gives an overall indication of how reliable you are as a borrower. This can feel unfair, especially to those struggling to rebuild credit, as the score might be weighed down by financial behaviors you've long since improved upon. While rebuilding credit can take some time, it is possible with consistent timely repayments.

However, it's not only timely payments that shape your score. In addition to a history of making payments on time, other factors include:

Credit utilization

Out of all the credit presently available to you, how much are you currently using? If you have a credit card with a limit of $200 and you've spent $100, this would be a 50% credit utilization. (Keep in mind that it doesn't matter what your monthly statement says you need to pay at this time — it's calculated by the total of what you owe them.) Ideally, you want your total credit utilization to be 50% or lower. Those trying to pick up the pace when it comes to building credit should keep it at 10% or under.

Length of credit history

Lenders want to know that when you open a credit card, you plan to stick around for a while. Credit card companies don't make money on the customers who use the card for a major purchase, pay it off, then immediately close the account. (If anything, they lose money on these customers.) This is why it's a good idea to keep your credit accounts open for as long as possible, unless you're overwhelmed by the fees or have had a bad experience with the company.

Types of credit

A desirable borrower is generally someone who utilizes various types of credit, such as credit cards, auto loans, etc. While this is a smaller factor in determining your credit score, it can be a way to boost it. While you shouldn't take out a large loan specifically to raise your score, various credit types will positively affect it.

How to select a credit card that actually rewards your lifestyle

There are many, many different types of credit cards in the world. There are credit cards with rewards, such as credit cards that provide airline miles or cash back. There are credit cards specifically designed for people trying to improve their credit score, such as secured credit cards, which require you to make a deposit to the lender equal to your credit limit.

There are also many credit cards that are what most people would call "just okay." They don't have any perks, but they don't come with any fees, and they help you to build your credit history. Many credit cards advertised as student credit cards fall into this category — they're not for big spenders trying to save money on international travel, but rather for college kids looking to newly establish themselves as credit users.

Choosing the right credit card involves considering your goals as a borrower. Do you need to build back your credit after a few years of financial difficulty? Then a secured card or a credit card advertised for those with fair or bad credit is the smart choice. Are you doing well financially, but feel that your money could be doing more work for you? Look for a card with cash back perks or points for hotels and dining.

Always remember to read the fine print, rather than just trusting the credit card company's flashy advertising. Sometimes companies will hide the parts of the agreements that aren't as appealing to the consumer, such as a monthly fee or a bad APR.

Understanding APR: The cost of carrying a balance

One of the most important factors to consider when choosing a credit card is the APR, which stands for Annual Percentage Rate. This is the percentage that your lender charges you of the balance you carry from one month to another so that they can, to put it bluntly, make a profit. A higher APR means that you'll pay more if you carry a balance from one month to another. While the lender doesn't want you to miss payments, they do want you to make the minimum payment, because that means that they can charge you interest each month.

The good news is that you're allowed to be your lender's least favorite type of customer — the customer who only utilizes 10% of their credit limit and pays off their balance every month before they can be charged the APR. By utilizing credit cards in this fashion, not only will you gradually raise your credit score, but you'll open yourself to new credit opportunities. When credit card companies have deemed you a reliable customer, they tend to throw their best products at you to entice you to spend more. You'll often be offered higher credit limits, credit cards with better perks, and sometimes even lower APRs.

Your next steps - consistency and smart choices

Credit building isn't rocket science—it's just about knowing the rules and playing the game smart. Now that you understand how credit scores work and what to look for in a credit card, you're moving in the right direction.

Start with a focus on consistency. Pay on time, keep your utilization low, and make informed decisions when choosing cards. Your future self will thank you for the financial doors these habits will open.