In its simplest explanation, credit is your reputation of handling borrowed money. When banks lend money to borrowers — like you — who need to make a purchase, your credit history allows them to evaluate how trustworthy you are to pay back the money. They will also use your credit standing to set the rules for your loan.
Your credit lets the bank know how much of a risk it is taking in lending money to you. While it is always best to simply purchase what you can afford on your income, getting a loan from a bank can help with bigger purchases such a house or a car.
Credit cards give you the ability to buy pretty much anything with the intent to pay it back later. From gas and groceries to clothes and electronics, credit cards offer various benefits to use their products, but should be used wisely.
Once a bank deems you can be trusted to pay it back, the evaluation does not stop there. The bank charges you a fee, known as interest, for the ability to borrow the money. This means anything you buy based on credit will actually cost more than its initial price after you pay it off. Those with good credit can get a lower interest rate — saving them money over the long run — while those with not-so-good credit are stuck with higher interest rates or aren't allowed to borrow money at all.
Why is credit important?
Your credit equates to your financial reputation.
Repaying loans consistently and on time builds confidence. Late or missed payments erode your credibility with lenders, potential employers and more.
Establishing good credit early allows a bank to know it can trust you to repay a loan — such as a mortgage or a credit card balance. By setting rules according to a person's history of paying bills, banks protect themselves from lending money to those who might not pay it back and encourages borrowers to pay their bills on time.
But how do banks figure out if you have good credit, bad credit or somewhere in between? Simple: You're assigned a number.
Credit bureaus base this number, known as a credit score, on a variety of factors such as how long you have been borrowing money, how much money you have borrowed, your record for paying bills on time and your income.
Credit scores can range from a maximum of 850 to 300, a number so low it is rarely seen, according to national averages. The higher your score, the more likely you are to get a loan and a good interest rate.
But your credit score does not stop affecting your life at the loan officer's desk. If you have good credit, you might be able to rent that perfect apartment or get a mortgage loan for a house you can afford in a neighborhood where you want to live. Good credit can help you get the car you need to take you to the job you want and even help you get that job. A low credit score may prevent you from doing all these things.
How do I know what my credit is like?
Your credit report, also known as a credit file disclosure statement, includes a list of items that determine your credit score. It shows information about all your credit cards, loans, medical expenses or other outstanding bills. It will also include your payment history and patterns, along with details such as whether you usually just make minimum payments on debt.
There are three credit bureaus that keep track of your credit: Experian, Equifax and TransUnion. Equifax sells a credit score calculated by the Fair Isaac Corp. method, known as a FICO score, while TransUnion and Experian provide a score calculated by their own formulas. Your score can vary from bureau to bureau.
It is important to check your report and make sure it does not contain any errors, particularly when you will be applying for a mortgage or car loan. If you find mistakes, you can report them and get them addressed to improve your score.
Under federal law, you can get a free copy of your credit report from each of the bureaus by applying here: https://www.annualcreditreport.com/cra/index. This only gives you a free report — not your score — but there are options to buy your score from the credit bureaus.
Tips for improving credit
It is important to pay all your bills on time by their due dates. Missing or making a late payment can bring down your credit rating. If you have a low credit score, making numerous on-time payments in a row can help increase it.
It is also important to watch how much credit you have, such as the limits on your credit cards, and how much you are using.
When it comes to using credit, what's most important is to live within your means and make careful plans about how to pay back any money you borrow.