What Is Credit & Why It’s Important

Credit Score person holding a wallet with their credit cards

Whether it’s good or bad, nearly everyone has credit — but what exactly does that mean? Although you’re probably familiar with credit cards and credit scores, the concept of “credit” itself may be a little fuzzy. Credit is all about borrowing. Simply put, credit allows you to receive something now that you’ll pay for later. It may sound easy enough, but understanding credit, how it works, and what it’s used for can help you feel more in charge of your finances.

Before we answer some common credit-related questions, there are a few terms you should be familiar with. A credit bureau is an agency that collects and distributes individual credit information in order to create a credit report. Those credit reports contain detailed information about you as well as your current and past financial obligations. This information about your credit history comes from lenders you have borrowed money from. Your credit history is a record of your ability to repay debts, including several aspects of your financial history such as the number and types of credit accounts you have, whether your bills are paid on time, and the amount of available credit you’ve used. And finally, your credit score is a number calculated based on these factors that expresses how likely you’ll be able to repay a loan.

Credit FAQs

person checking their credit card

How Does Credit Work?

If you’re not familiar with the concept of credit you might think getting money now and paying later might sound too good to be true, but of course, there are processes in place to protect lenders from borrowers running off with their money. Whenever you take out a loan you’ll be required to pay back that loan, plus interest and potentially other fees and often within a certain timeframe. The lender may report your repayment to a credit bureau, and missed payments may negatively impact your credit score.

What Is Credit Used For?

While traditionally just a metric used by lenders, credit reports are now used for a variety of things, from borrowing money to getting a job. 29 percent of employers who run background checks say they run credit checks on potential employees. As a result, a poor credit score can penalize you in more ways than one.

Here are some of the main reasons credit is used:

  • Securing financing: The most common reason credit is used is to determine eligibility for a financial loan. Lenders look at your credit report as a way to measure your financial standing against your ability to repay a loan. Typically, better credit scores result in better rates, while having a bad credit score or no credit drives rates up (or in some cases excludes you from even getting a loan).
  • Renting a home: Your landlord might request a credit check before signing the rental agreement. A poor credit score could cause the agreement to fall through or result in a larger security deposit. Utilities often operate in the same way.
  • Applying for a job: Some employers may ask for a credit check as part of the hiring process. It’s likely that they’re using this as a measure of responsibility, especially for jobs that require dealing with finances.
  • Insurance coverage: Your ability to find affordable insurance coverage also depends on your financial responsibility. Insurers check a form of credit score, called an insurance score, to determine whether to cover you as well as premium rates.

Why Do I Need Credit?

While some people are hesitant to get a credit card, very few people live with no credit history. In fact, you don’t even need a credit card to build credit. Whether you decide to open a credit card or not, there are still a lot of upsides to having good credit. Even if you’re not planning to take out a loan anytime soon, having good credit can help you get better insurance rates, get approved for renting an apartment, and teach you healthy financial habits.

person checking their budgets with a calculator

What Does it Mean to Have “Good” Credit?

Having good credit essentially means you are financially dependable. Lenders can count on you to repay any loans. If you’re wondering what a good credit score is, in general, a score over 700 is considered a good credit score. It is possible to build credit if your score isn’t where you would like it to be. And you don’t even need a credit card to do it!

Different Types of Credit

credit card illustration representing the different types of credit

There are four main types of credit. Each type differs slightly in the repayment method, but the main concept is still the same.

  1. Revolving credit is credit that can be reused as debts are paid off. Traditional credit cards are a prime example of this. For example, if you have a $1,000 credit limit and you charge $200 on your credit card, your total available credit drops to $800. But as soon as you pay back that $200, your credit limit is reset to the original $1,000.
  2. Charge cards work similarly to credit cards, but unlike credit cards that can carry a balance month-to-month, the balance on a charge card must be paid in full at the end of each statement.
  3. Installment credit is a loan with a specified monthly payment, term, and interest rate. As the name suggests, the borrower will pay back the full amount borrowed in installments over a set term. Some examples of this type of credit include home mortgages, car loans, and student loans.
  4. Service credit is an agreement with a service provider that you will pay a monthly bill. Your electricity, cell phone, and gym membership are all examples of service credit. However, not all service credit is reported as part of your credit history.

Now that you know why and how credit is used, you have more insight into how your credit score might affect your life. Just remember, if you’re concerned your credit score isn’t good enough, there are ways to build your credit whether or not you have a credit card. Regularly checking your credit score can help you feel more prepared and less blindsided in the event that anything negative comes up.

Sources:

Debt.org | Why Credit History Matters and How to Help Grow It – Mint.com | WTFinance: What is a Credit Score? – Mint.com

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