Credit is almost a necessity in today’s financial world. If you don’t have credit you’ll end up having to pay cash for everything and if you’re not already affluent or have a high-paying job, that can be a difficult process.
You can't build a reputation on what you're going to do.Confucius
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What is Credit?
Credit is the ability to borrow money or access goods and services with the understanding that you’ll pay it back later. A bank or company extending credit typically means they trust you enough to receive some kind of resource now and you’ll pay them back over time either in full or in monthly payments.
Lenders, merchants and other service providers will extend credit to you based on their confidence that you can pay it back. A lot of factors go into deciding if you are “credit worthy”.
How does credit work?
Historically there was no way to actually calculate your “credit worthiness” so many banks and lenders would simply extend credit based on reputation. This isn’t a sustainable methodology and so the modern way to calculate scores was born.
A creditor will look directly at your credit history as the first step in determining if they should lend you any money. This history is compromised of several files known as your credit report. These reports are compiled by independent credit bureaus: Experian, TransUnion and Equifax.
Banks, credit card companies and other creditors will report your usage of their services and payment information to these bureaus who then calculate your score with their own scoring models.
Your credit report will typically house information like your ability to pay your bills, all of your credit cards, any loans you’ve taken out and any severe financial setbacks you’ve faced like bankruptcy or repossession.
Based on all of this data these creditors use a three-digit number, known as your credit score, in deciding whether or not to issue you credit. It’s a rating based on your credit report for how likely you’re able to pay back the debt you owe them.
What are the types of credit?
There are four types of credit:
- Revolving Credit: Revolving credit is when you’re given a maximum borrowing limit and you can borrow up to that amount and you just make monthly payments. These accounts carry over month to month as long as you have a balance on the account. The best example of revolving credit is a credit card.
- Charge Cards: A charge card is issued by retailers for use only in their establishment or store. These are a lot harder to find and are almost identical to credit cards. The key difference is that you’re required to pay off the charge card each month and no retain a balance.
- Service Credit: Service credit is your contract with various service providers, like utilities or cable. The companies provide you with a service each month with the understanding that you’ll pay your bill for their services.
- Installment Credit: Installment credit is another term for a loan for a specific amount of money. You agree to pay this loan back in monthly payments over a set period of time. A student loan, car loan and even a mortgage are all examples of an installment credit.
Why do we need credit?
Unless you can pay cash for everything, you will need credit for most major purchases and financial decisions. It’s important to build credit at a younger age and keep your credit as good as you can. You’ll want to maintain a credit score of 580 or higher. A higher credit score means you get the best interest rates and terms on loans and credit cards.
However, your credit isn’t just used for borrowing money. It’s also used to review your entire financial situation and may be used against you when it comes to renting or getting auto insurance.
You may end up in the following scenarios:
- A landlord may check your credit when deciding if they’ll rent to you and a lower credit score could mean a higher deposit.
- Insurance companies may raise your rates if your credit score is lower.
- Utility companies, like electric or gas, may not allow you to have an account under your name if you have no credit.
- In some cases, employers will use information in your credit report for a hiring decision.
- Your credit report can be used for identity purposes.
Establishing credit and building your credit to be as best as it can be will open a lot of doors for you financially. It’s best to start when you’re younger as the longevity of your accounts does matter. If you’re having a hard time starting to build credit take a look at our guides and resources to help you find unique ways to build credit fast.