Credit is the ability to purchase goods or services without paying cash. It is a vital part of personal and business economics. Most people don’t think about credit until they find that they need it and don’t have it.
A credit score can have a significant impact on your financial well-being. It plays a major role in your ability to buy a home or car, receive approval to rent an apartment, or use a credit card. A brief introduction to credit and the various reasons it is vital will get you started on the road to financial success.
Credit Score Basics
There are three different credit reporting agencies that are responsible for collecting all of the data that makes up your credit score: Experian, Equifax, and TransUnion.
The scores assigned by these companies range from 300 to 850, with 850 being a perfect credit score. The scores are based on data sent to the companies from lenders and other entities that provide credit, such as banks, credit card companies, hospitals, and utility companies.
Some of these entities report to all three agencies, while others report to only one. The companies then use this information as a whole and generate a credit score. The credit score model was created by the Fair Isaac Corporation, also known as FICO, and is used by most financial institutions.
The three agencies use several different factors to determine your credit score. Some of these factors include your payment history, credit utilization, and length of credit history. If you pay all your bills on time, keep your credit card balances low, and have had a credit card or loan for several years, you will most likely have a pretty good credit score.
When you apply for credit with other companies or banks, your credit score determines your creditworthiness. This is just one reason your credit is essential and remains that way throughout your entire life.
Many people don’t think about credit until they want to buy their first car or house and find they don’t have a credit score. Parents have often provided for all the financial needs, and you haven’t had to think about credit or lack thereof.
It doesn’t take long to find out that you need credit and that you need to understand it and how it is used throughout your financial life. Once you understand, you can take steps to keep your credit healthy and available when needed.
FICO 101
Everyone with a credit file has a FICO score. This number shows your ability to repay a loan and helps determine how much money you can borrow, how long you can borrow it, and how much interest you will pay. FICO is an industry standard, and it is possible to have a different FICO with each credit bureau.
Your FICO or credit score will go up and down during your life, monthly as the agencies report their findings. Sometimes, the change is insignificant, or no change is reported at all. However, if you have missed payments on existing credit, opened new credit lines, used more of your existing credit, or even had inquiries into your credit, you could see large drops in the score.
If you have paid off credit cards or loans, it can take longer than one month to increase your credit score, but you will see it jump in time. Likewise, if you are making consistent payments on your loans, you will see your credit score increase over time.
When applying for credit, make sure your FICO is the standard used to make a decision. Other companies provide credit scoring, but the industry standard continues to be FICO.
What Information Is on Your Credit Report?
The information on your credit report is as important as the score. There is a wealth of information on the report about your financial habits, including:
- Creditor and amount of credit extended
- Amount of credit left and amount outstanding
- Number of payments made on time
- Number of late payments
- Status of account, such as closed, active, or in judgment
This information helps lenders determine if you are worth the risk. If a potential lender is hesitant due to a lack of credit history but sees that you do make payments on time for the ones you do owe, they might be willing to take a risk on you. On the other hand, if the only accounts you have show delinquent payments and consistently use all available credit, you might appear to be high risk.
10 Examples of When You Might Need Credit
Here are several different examples of when having credit can be useful.
1. Getting an Auto Loan
The first big purchase most people make is a car. Unless you have saved money from summer jobs or have parents buying a car for you, you will need credit to get a loan to buy the car. If you are starting out on your own, you may find it challenging to get a loan due to a lack of credit.
If you have a source of income that can be verified, you can often find banks that have first-time loan offers. These loans typically come with a higher interest rate but will help establish credit.
Auto loans from “buy here, pay here” car dealers can help establish credit if they submit payment history to the credit bureaus. If you choose this route, ask the dealer if they report the payments to your credit report. If they don’t report to credit bureaus, try to locate a dealer who does. Your credit needs the information to grow.
2. Taking out Student Loans
After a car, student loans are often the next most important use of credit early in life. Student grants and scholarships don’t rely on credit scores, but obtaining money from private lenders or the state often requires having good credit or at least the start of a credit record.
Many young people are not able to attend college without student loans. Starting a credit record early and maintaining good credit can be a determining factor in obtaining the best education.
3. Getting a Mortgage
The biggest and most important reason for credit is purchasing a home, the biggest purchase you will most likely make. Credit requirements are necessary to get approval from a bank for a mortgage.
The need for credit for your home is not limited to purchasing a home. It can be difficult to rent an apartment or house without credit. The owners need to know payment will be on time, and your credit history is the best gauge.
When purchasing a home, you can sometimes buy some credit. If you have a large downpayment and steady income, lenders will be more apt to take a risk on your mortgage loan. They believe the large downpayment shows seriousness in taking on a home loan. The interest rate can be revisited once the loan has been in place for a few years, and you have established credit.
4. Applying for a Credit Card
Credit cards can be a lifesaver in a financial emergency. However, obtaining credit card approval can be difficult if you have bad or no credit. There are first-time cardholder options that are useful in getting and establishing credit.
Your credit is also important in determining the interest rate you pay on credit cards, both initially and during the card’s life. Initially, the credit card company will use your credit history to assess your credit risk. Your interest rate will be based on this information. Later, the company can pull your credit history to determine if you have earned a credit increase or better rate or if you will lose your credit limit and pay a higher rate.
5. Paying Your Utility Bills
It’s easy to think about credit only in terms of buying power. But, other important reasons make activities requiring credit more important than making purchases. Utility companies, such as water and electricity, require a deposit to hook up service. However, if you have established credit that is in good standing, you can often skip the deposit and have your power and water turned on without any money out of pocket.
6. Employment Opportunities
You might not think that your credit is important to prospective employers. While it isn’t a question found on most applications, credit access requests can be in job questionnaires, particularly for jobs in the financial sector. Employers want to know if you are responsible, and your credit score reflects your reliability and responsibility with money.
7. Getting a Cell Phone
A cell phone typically costs more than you want to pay out of pocket or all at once. Then, you have to add the cost of getting service. These high costs lead most people to add the cell phone to their monthly bill in a lease or annual program. The cell phone company uses your credit to determine if you can get the service and the phone you want.
Your cell phone bill can also be part of building your credit. This is another reason that your credit is vital to your financial health.
8. Applying for Insurance
Life and auto insurance policy applications typically request your permission to access your credit file. There are multiple reasons insurance companies want to see your credit score.
- High credit scores indicate financial responsibility. It shows you pay your bills on time and take your obligations seriously.
Many insurance policies are monthly obligations; your credit score helps the company determine credit risk. - In addition to determining insurability, your credit Is essential in determining your rate. Good credit often makes your auto insurance less expensive.
9. Billing for Medical Procedures
Hospitals often require payment upfront before procedures are performed. Admissions paperwork may request permission to access your credit to determine your ability to pay the hospital bills.
10. Establishing Independence
Unless you want to be dependent on your parents or a spouse for all your financial needs, credit is essential to establish and maintain. You should establish credit early in life and stay informed about your credit scores throughout your life. Good credit can keep you from turning to friends and family for financial help in emergencies.
The Importance of Checking Your Credit
Understanding the importance of credit is the first step in reaching the goal of good credit. Next, you should learn to check and maintain your credit file. You should request a copy of your credit report annually and go over every detail.
Once you have your report, print it out and check these details:
- Check all credit entries for accuracy. If you have items on your report that are inaccurate, make a note of these.
- Check the income section and ensure that the information is accurate and up to date.
- Note any negative entries for research and rectification.
If you find any errors, contact the credit bureau in writing and ask for correction. If there are negative entries, contact the lenders and either dispute the entry or make arrangements for payment so someone can remove the entry. It takes diligence for errors to be removed. Keep records of all contact with the bureaus and stay on top of the situation until it is resolved.
Takeaway
Now that you understand the importance of credit and know how to check credit, you may need to know how to rebuild your credit. It is easy to fall into hard times financially. It doesn’t take much to cause your credit to be considered risky. You can, however, take steps to rebuild your credit and increase your score.
Contact all creditors that you owe, particularly any that you have let lapse. Make arrangements to pay the balance owed and request that the creditor make changes to your credit report indicating your payments.
Reduce your credit card balances and make it a point not to use all of your available credit. Part of the credit score is based on available vs. used credit. Close accounts that you don’t need. Set yourself and your family a budget and stick to it while you are building your credit score. Avoid big purchases until you have your credit score in a healthy range. Once you have a good credit score, make it a priority to keep it healthy with good spending and saving habits.
Credit, and an understanding of credit, is essential in all aspects of life. It helps you get moving with your first wheels and stays with you throughout your life until your family utilizes the insurance it helped buy. It is up to you to understand the importance and keep your credit healthy.
