Everything You Need to Know About Credit
Why should you care about your credit?
Think about your current financial or life goals.
Do you want to qualify for an apartment?
Pay off your student loans?
Maybe you’re looking to get approved for your first credit card?
Well, these are all things that involve your credit. Your score determines what sort of loans you can get approved for, the deals on credit card limits and interest rates you can land, and even what sort of apartment you can live in.
But say you’re not terribly worried about any of that.
Consider this: Do you want the financial freedom to travel?
Do you want insurance?
Maybe to open a business?
Then credit matters to you, too. We’ll explain why, but first let’s go over what a credit score even is, and how it works.
What is a credit score and why does it exist?
Short answer: credit scores are a tool for lenders.
Better answer: algorithms comb through your borrowing history, utilizing information from your credit reports, to generate a score that essentially summarizes all the data.
This score helps lenders decide whether or not to approve loan applications, and what loan terms to offer. Having the score as a reflection of your borrowing history hints to banks and credit unions how much of a risk you might be to default on your loan.
Have you borrowed money and repaid it before? Or did you recently stop making payments on multiple loans? This is what lenders want to know before approving your application.
Scores range from 300 to 850 (300 being not great and 850 being perfect). Realistically, you probably won’t get an 850, but aiming for something around 700 is a great goal.
Your score is composed of your payment history, which involves missed payments, or times you’ve defaulted on loans; current debt, which is pretty self-explanatory — it asks how much debt you’re in; length of credit, which is your total borrowing history, specifically, how new you are to credit; new credit, which asks if you’ve applied for a lot of loans recently; and types of credit, which pertains to your concentration of debt, namely, whether you have a crushing amount of one category of debt or an even, manageable spread of auto, home, credit cards, etc.
Now, some people are too young to have developed a borrowing history — they’ve never taken out a loan before or had a credit card. These types of loan applicants can have alternative credit scores which gather information from other sources, such as utility bills and rent.
How do you get a good credit score?
Ensure most of your available credit is unused.
A general rule of thumb is to, whenever possible, leave 70% of your available credit alone. It serves as evidence that you’re a responsible credit-wielder and know how to budget to avoid debt.
If you use more, say, dipping into 60% of your available credit, your overall score could take a hit.
In a perfect world, you’d make all your payments on time, but our world is far from perfect and sometimes things come up or emergencies happen.
Just keep in mind, if you’re late, that the age of the late payment matters — the sooner you pay it off and the sooner you can put it behind you, the better.
There may be an initial decrease in your score, but as time marches on (and you don’t have any other late payments) your score will increase again.
Another bit of advice: know what your score is.
This seems pretty obvious, but it can be all too easy to ignore it and let changes go unnoticed. The more awareness you have, the easier it will be to make informed decisions, so it’s a good idea to keep an eye on your score.
You can access free reports (but not scores) once a year at AnnualCreditReport.com, which will give you a general overview.
Mint and CreditKarma are great personal finance apps that will show your score, or alternatively, you can check to see if your bank offers score reports.
How do you establish a positive credit history anyway?
Borrow money, then pay it back — on time!
Of course, there are different methods of doing this, which we’ll get into below.
First off, there are loans.
Not all loans are equally easy to qualify for.
Cash-secured loans are probably one of the best to start out with because you’ve essentially already paid them off.
How does this work?
Well, say you have $200 dollars in your savings account, and you need a loan for another $200 dollars. Lenders wouldn’t be risking much here, because you’re borrowing against money that you already have.
If you don’t make your payments, they’d just extract the $200 you already had to fulfill whatever debt you’d acquired. Cash-secured loans are pretty easy to qualify for for that reason, and if you make your payments on time and in full, it’ll improve your credit score.
There are a few other ways to improve your score or (if you’re a newbie) establish a history. Two of the best ones are cosigners and credit cards. Let’s go over both briefly.
- Cosigners: If there’s someone in your life who is financially stable and willing, they can promise to repay your loan if you fail to make your payments, even though you’re the one who’ll get the money. They file your application with you and are essentially the reason you’ll get approved.
- Credit Cards: If you can use them responsibly, credit cards can help you establish a credit history. Provided you keep the balance at zero most of the time and don’t max out, they’ll improve your credit by building a history of a positive borrow-repay cycle. Student credit cards in particular are a great way for younger people to get started building up a credit history.
Why do you even need credit?
Short answer: lenders can’t trust you if you have a low credit score or no credit history.
Better answer: If you don’t have a score or credit history at all, then lenders have no idea what to expect from you and likely won’t want to risk giving you money. On the other hand, if you do have a credit history but your score is low, then lenders will assume that you won’t be able to pay back a loan on time.
With that being said, loans aren’t the only reason you need credit; it also has ramifications for rent and insurance.
Landlords are kind of like lenders, except you’re borrowing a residence instead of money. Oftentimes they’ll need to see your credit score and history before approving you for their apartment or house.
Essentially, your credit is their way of telling how responsible or financially stable you are, and whether you’ll pay rent on time.
In a similar vein, your insurance rates are affected by your credit.
While your credit score isn’t the best gauge of whether or not you’ll crash your car, it will still be a big determinate in what sort of coverage you can get when applying for insurance.
They are basically measures of reliability — even if it is incomplete information, insurance companies rely heavily on intuiting what sort of person you are based on your score.
You can live without a credit score but having one — and a good one at that — makes life a lot easier.
It might be challenging at first to keep track of your spending habits and work towards building up your history, but taking your financial future into your own hands is an empowering experience that opens up your financial options and eases stress down the line.
So whether you’re a student trying to figure out how to start building a credit history, or recovering after a series of missed payments, there’s absolutely a way to get started on a journey to better credit.
Utilizing your annual free credit report to check that your reports are error-free, and making payments on time (or avoiding taking out loans if you know that you’ll miss your payment deadlines) are great ways to get started.
Significant changes don’t happen overnight, but over time, meaningful improvements can be made.