What is Credit?
Simply put, credit is the trust you build that allows lenders to see you as a viable borrower. As a consumer, credit is your ability to borrow money and prove yourself reliable to someone else on the assumption that you’ll pay them back in the future. Your credit history is an indication of your creditworthiness, so if you have “good credit”, you’ve demonstrated yourself as a reliable borrower.
A person with little or no credit history will have a more difficult time getting approved to borrow money from a financial institution or lender because they haven’t yet demonstrated their trustworthiness as a borrower. He/she may be perfectly able to pay back a loan, but there is no record of their credit history to assure lenders of their ability to do so.
Credit Reports Versus Credit Scores
There are several ways lenders may assess you as a potential borrower, with two of them being your credit reports and your credit scores.
Credit reports are detailed records of your financial history, including:
- The credit accounts and outstanding loan balances you have open
- The amounts of any loans you’ve taken out or credit you’ve utilized
- Your payment history on debt balances
- Your payment history on utility accounts
- Any severe financial difficulties you’ve faced such as bankruptcies, mortgage foreclosures, or vehicle repossessions
In the United States, every person has three credit reports on file, one from each of the three major credit bureaus: TransUnion®, Experian®, and Equifax®. Lenders typically report activity on consumers to one or more of the three credit bureaus. So while your reports should contain similar information, there may be minor differences among them. (Large differences warrant further investigation, as they may indicate a mistake or fraud on your report.)
In addition to credit reports, lenders may also use credit scores to further determine their lending decisions. Your credit scores are essentially a summary of the information on your credit reports in the form of a three-digit number. Like your credit reports, you also have more than one credit score (depending on the company who calculates the score). There are two main credit scoring systems used in the US: FICO® and VantageScore®. FICO is the most common score used by lenders. FICO scores range from 300 to 850, with good credit scores ranging 670 to 739, great credit scores ranging from 740-799, and exceptional scores ranging from 800 to 850.
FICO credit scores are determined by a number of interrelated factors, with some carrying more weight than others. FICO calculates your score based on your payment history, the amount of debt you owe, the length of time you’ve had open credit accounts, the mix of different types of credit you use, and the number of new credit inquiries on your report. When it comes to credit scoring, having the right kind of financial activity matters. No activity in one or more of the five scoring categories will negatively impact your score, while too much activity may also have negative consequences. To build good credit, you essentially need to demonstrate responsibility by having some activity in all five categories.
Why Is Credit Important?
As stated above, building a good credit history gives you financial power and access to opportunities you wouldn’t have otherwise. Although credit cards aren’t a replacement for a solid emergency fund, having access to credit cards with decent credit limits can give you some peace of mind that if an emergency does occur, you’ll be able to cover yourself.
Equally important, there are other reasons why building good credit history is important. Building good credit history provides you with:
- The ability to qualify for mortgages and vehicle loans
- Access to lower interest rates and better loan terms
- Good standing in the eyes of employers and landlords
- Better insurance rates
Ability to Qualify for Mortgage and Vehicle Loans
Homes and vehicles are expensive, and most people don’t have the ability to pay for these big-ticket items with upfront funds. (Interestingly, there are sometimes compelling reasons not to do so.) Therefore, having sufficient credit history is essential if you ever want to qualify for these types of loans. Without credit history, lenders have no way of determining your ability to repay, so they simply won’t take the risk of lending you money. And because building credit history takes time, it’s important to start doing so well before you plan to purchase a home or finance a vehicle.
Access to Lower Interest Rates & Better Loan Terms
Not only does good credit allow you to qualify for loans, but the better your credit, the better terms you’ll be offered on these loans. If your credit meets the criteria for the lowest possible interest rate, you could end up paying much less in interest over the life of the loan. Depending on the lender requirements, the terms you’re offered might differ significantly from a person who has a credit score just 20 points higher.
For example, let’s say you have a credit score of 650 and you qualify for a vehicle loan of $30,000 to be repaid over 60 months (FICO considers a credit score of 650 to be “fair”). You might be offered an interest rate of 6.61%, which means your monthly payment would be $588.53. Over the life of the loan, you would pay $5,311.80 in interest.
A credit score of 670, however, (just a 20-point increase) could possibly lower your interest rate substantially (for instance, to 3.48%), resulting in a monthly payment of $545.48. Even if a monthly difference of $43.05 doesn’t seem like much, you would only pay $2,728.80 over the life of the loan! That’s a savings of over $2,500 in interest— just for a 20-point increase in your credit score.
Good Standing in the Eyes of Employers & Landlords
Lenders aren’t the only ones who check credit scores. Oftentimes, employers or landlords will also run a credit check, not because they’re lending you money, but because good credit scores can be indicative of the ability to make regular, timely payments. When the job market or demand for rental properties is highly competitive, a good credit score can sometimes be the deciding factor between you and another candidate.
Better Insurance Rates
Insurance companies may also run credit checks on people who submit insurance applications. Creditworthiness is just one factor insurance companies use to assess when creating a new policy. While you don’t have to have perfect credit to be approved for an insurance policy, your credit score may influence the rates you’re offered.
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