You’ve probably heard the term credit. You may already know that this is an important part of building a solid financial future. But no one ever seems to talk about the specifics. For starters, what exactly is credit and why is it so important?
In a nutshell, building a healthy and solid credit history is an important part of your financial health. Just like it’s important to save a portion of your income, improving your credit can help you rent an apartment and get approved for a loan.
Are you ready to learn more about credit? We’ve got you covered. Here’s everything you need to know to begin understanding credit.
What is credit and types of credit
When you buy something with credit, this essentially means you’re purchasing it now with the promise to pay for it later. Two common types of credit include installment loans and revolving credit.
Types of credit
1. Installment loans
This is when you borrow a set amount of money and use it for a specific purpose, like a car loan, a student loan, or a mortgage. When you pay for something with installment credit, you’ll make equal monthly payments that include interest.
2. Revolving credit
This is when a lender gives you a line of credit – up to a certain limit – and you then borrow from that amount and pay it off over time or even in one lump sum if you can. A common type of credit line comes in the form of money you spend on your credit card. In this instance, a credit company will extend to you a certain amount of credit and you can spend up to that amount. Your payments each month will fluctuate based on how much you’ve borrowed.
How does a lender decide whether to loan you money?
Let’s say you decide that it’s time to buy a car. You don’t have the cash to pay for it, so you apply for a loan. Easy peasy, right?
Not so fast. Before you can typically borrow that money, a lender needs to feel comfortable that you’re actually going to repay the money. To do this, the lender will look at a number of factors. The most important criteria is your credit history.
Credit history, credit report, credit score. What do these all mean?
Your credit history reflects how you’ve spent money over a length of time.
This may include how many credit cards and loans you have and whether you’ve paid your bills on time. If you’ve been paying for almost everything in cash and you’ve never borrowed any money, you probably won’t have much of a credit history. If you do, it will be summarized on a credit report.
Lastly, a credit score is a number that is calculated based on your credit history. This three-digit figure indicates to a lender how likely you are to repay your debts. A higher credit score means you have a better credit history. A lower credit score means you have a bad credit history. Most of the time a lender will use your FICO credit score when deciding whether to lend to you. These scores range from 300-850.
If you don’t plan on borrowing money, should you really care about credit?
If you ever want to rent an apartment, get a cell phone plan, or buy a car, you’ll likely need good credit. Your landlord, utility company, or mobile phone carrier might check your credit. Your future employer might even check your credit.
Even if you don’t plan on borrowing money anytime soon, it’s still a good idea to build up your credit. You never know when you’re going to need it. For example, you might decide someday that you’d like to buy a house. If you have a solid credit history already in place, you’ll have a much easier time qualifying for a mortgage or any other type of loan.
Your credit history doesn’t only impact whether a lender will loan you money. It also impacts how much you pay in interest. Borrowers with a good credit history are considered less risky so lenders will usually offer them lower interest rates. And, lower rates can potentially save you thousands of dollars over time.
How does someone get a good credit score?
At a basic level, good credit comes from paying your bills and making your loan payments on time. But there are a few more things that go into it:
- Don’t max out your credit. Lenders will want to see that you haven’t borrowed too much money. For example, if you have a credit card with a $10,000 credit limit, it’s a good idea to keep that balance as close to zero as possible. Experts advise keeping your balance below 30% of your credit limit. In this case, that would be $3,000.
- Apply for credit only when you need it. Applying for multiple loans at once can signal to lenders that you’re having trouble with your money. So, try not to rush out and get a lot of credit cards at the same time.
- Work on improving your credit history. The longer you’ve been building your credit, the better your score will be. Years of making on-time payments will show that you’re a trustworthy borrower.
How can I start building credit?
There’s a famous quote that says the best time to plant a tree was 20 years ago. The second best time is now. If you haven’t started building your credit history yet, now’s the time to begin.
Start by getting a free copy of your credit report from each of the three credit reporting agencies. You can also request a free credit report each year by going to AnnualCreditReport.com. Once you have the report, start by checking the information and making sure it’s all correct. The report will also include recommendations on how to begin improving your credit.
If you don’t have any credit history and you need to begin building it, there are a few easy ways to get started:
- Get a secured credit card: With a secured credit card, you make an upfront deposit, which is usually your credit limit. If you make a deposit of $1,000, for example, you’ll have a credit limit of $1,000. After that, it works like a regular credit card. You use it to make purchases and then make on-time payments to build your credit score.
- Become an authorized user. Do you have a friend or family member that has good credit? He can add you to his credit card as an authorized user. The catch is that your friend will be on the hook to pay for anything you charge and if his credit declines, this can also negatively affect your credit score.
- Apply for a store card. It might be easier for you to qualify for a store credit card, one that you are only able to use while shopping at that particular company. Just be aware: Store credit cards often come with higher interest rates, so be sure to pay off your balance each month.
Understand Your Credit and Improve Your Financial Future
As you can see, building good credit is a long game. Yet, if you play the game right, you’ll be on your way to a healthy financial future.
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