You likely know that credit is an important part of building a solid financial future. From borrowing money to making purchases, credit is a part of our day-to-day lives.
But do you know the specifics? For starters, what exactly is credit and why is it so important? If you’re ready to learn more, we’ve got you covered. Here’s everything you need to know to begin understanding credit.
What is credit?
Credit is your ability to borrow money and pay it back. It involves a relationship between you (the borrower) and often a bank or other financial institution (the lender). Two common types of credit are installment loans and revolving credit.
| Installment Loans | Revolving Credit |
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How does credit work?
When you buy something with credit, you’re essentially purchasing it now with the promise to pay for it later. Now you’ve likely heard about “good” credit and “bad” credit. This refers to your reputation or history of borrowing funds and paying them back.
Individuals with good credit have a history of making regular on-time payments. Those with bad credit often have a history of missed or late payments. You build credit by continuing to borrow and pay back money.
There are several different ways you can work to boost your credit, including:
- Paying your bills
- Making loan payments on time
- Not maxing out your credit and keep your balances as low as possible
- Applying for credit only when you need it
- Investing in building a strong credit history
If you don’t have any credit at all, there are many great ways to get started. For example, you can take out a credit card or become an authorized user on another account.
How credit is determined
When determining your credit, your credit history, credit report, and credit score all play a role. But what do they mean?
Credit History
Your credit history is your history of borrowing, spending, and paying back money. Here are some things that make up your history:
- All of the credit accounts you’ve opened and closed
- How much you owe on each of your credit accounts
- Your payment history, including payment amounts and timeliness
Your credit history is essentially your track record of using money from lenders and working to pay it back.
Credit Report
Your credit report is basically a record of your credit history. It documents how you’ve managed your credit for future lenders to take a peek at how reliable you are with debt.
Credit reports are typically generated from one of the 3 main credit bureaus. These are Equifax, TransUnion, and Experian. They’ll include some personal information, info about your credit accounts, and a section about inquiries into your credit.
Inquiries may be hard or soft. A soft inquiry generally doesn’t affect your credit score. This can happen for a prequalification or if existing credit accounts are considering giving you a credit limit increase. Hard inquiries can damage your credit score. They happen when you’re applying for a loan, credit card, or other form of credit.
Credit Score
Your credit score is a three-figure score ranging from 300 – 850 that shows your creditworthiness. Think of it like getting a grade based on your relationship with credit so far.
A good credit score emerges from paying your bills on time and maintaining a healthy level of credit utilization. A bad credit score comes from not paying your bills, consistently paying them late, or having several credit accounts open at the same time.
Lenders, credit unions, banks, and other financial institutions will use credit scoring to generate a personalized score. They take the following into account:
- Payment history
- Number of open accounts
- Length of credit history
- New credit
- Diversity of credit
It’s important to know and understand your credit score to get a grasp on your financial standing.
Why is credit important?
Credit matters for a lot of reasons. It sets the tone for your financial health and determines whether or not you can access money when you need it most.
Credit will determine your approval and interest rates for things like auto loans, personal loans, and sometimes even your rent or cell phone plans. Being creditworthy helps ensure you get financial help when you need it, and don’t end up paying extra with high-interest rates.
Keeping a pulse on your credit, and finding ways to improve it, will pay off in the long run. It’ll help show you’re responsible and reliable, opening up more opportunities for you.
Credit 101 FAQs
Still trying to wrap your head around what credit means and why it matters? Here’s some more info.
Why is credit so important?
Credit determines whether or not you can access money. Whether applying for a loan, buying a house, or considering a credit card, your credit can make or break your experience. It will determine if you’re approved, and at what interest rates.
Does credit matter if I don’t need to borrow money?
Even if you’re not considering borrowing a big amount of money, credit is still important. It plays into things like cell phone plans, your rent, and buying a house. Even if these aren’t priorities for you right now, they may be in the future.
How can I start building credit?
Start building your credit by paying your bills on time and looking for opportunities to open credit accounts (but not too many!). Apply for a secured credit card or become an authorized user on someone else’s account — these are just a couple of options to consider.
How does someone get a good credit score?
Strive for a good credit score by making regular payments and making them on time. Consider going for more than the minimum payment and paying off accounts when you can. Small, good financial habits can have a large impact on your credit score in the long run.
Bottom line
Building credit takes time, and there are a lot of factors to consider. But with the right amount of patience and effort, it can give you peace of mind that you’ll be able to borrow money when you need it.