What is credit? Why does it matter? Read on for a crash course on everything you need to know.
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 |
|---|---|
• You borrow a set amount of money for a specific use • Pay it back with monthly payments including interest • Examples: student loans or mortgage | • You get a line of credit from a lender, up to a certain limit • Borrow as you need it, and pay it off over time or in a lump sum • Example: credit cards |
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.