Credit: The Basics

Credit is that thing we need to get a car, a phone, a credit card, a house, and essentially every other utility and important purchase of goods and services. Yet, many of us don’t know what it is and how it works because no one ever told us about its importance. Most of us never learn about it until we go and try to buy our first car and the bank won’t loan money to us unless we have a cosigner with a good credit history or when we go to the cellphone company and they deny us a new phone because we have no credit history. This information is incredibly relevant, especially to college students who are just starting to gain credit experience. So, what is credit, how does it work, and how can we build it and maintain it?

What is credit?

Credit is a financial term that is generally defined as the ability to borrow money, goods or services in exchange for agreeing that they will be paid for at a later date. It also can refer to the credit history of a person. Credit is granted by creditors who do so based on the confidence they have on a person’s ability to pay back, with interest, the money, services, or goods that were borrowed. Creditors determine whether or not to grant a person credit by looking at a person’s credit history; that is, their history of borrowing and repaying funds.

A person’s credit history can be seen in credit reports provided by credit bureaus; the three main being Equifax, TransUnion, and Experian. Credit reports are summarized by a three-digit number called a credit score; they also include the amount of loans you’ve taken out and how much you’ve paid back, the number of credit cards you have (with balances and borrowing limits), the monthly payments that you’ve made on time, the ones that were late or the ones that weren’t made; and foreclosures, car repossessions, and bankruptcies. 

There are different models that calculate a credit score, a common one being the FICO score. The FICO score ranges from 300 to 850; 300 being the lowest and worst score and 850 being the highest and best score. However, any score between 600 and higher is still considered good. The higher the score, the more confident creditors will be in a person’s ability to pay back the debts with interest. 

The types of credit. 

The multiple types of credit are service, installment, revolving, and open credit. Service credit refers to the contracts a person has with a service provider, like an internet provider, a cell phone company or an electricity company. Companies like these provide a person with a service in exchange for them agreeing to pay for that service each month. This is why your credit will be affected if you do not pay your cellphone on time. Service credit is one of the first ways a person begins to build their credit, therefore it’s one of the most important ones. 

Another type of credit is installment credit; this type refers to the loans a person takes out. Installment credit is the type of credit commonly used for large purchases; such as a student, car, or mortgage loan. Paying these loans on time is the only way that it will not affect a person’s credit score. However, it’s important to make smart decisions and borrow installment loans from credible institutions because not all loans are of equal benefit; in fact, borrowing from smaller institutions (like a finance company) and having them show up on a credit score can even lower someone’s score. Always avoid in-house financing when shopping for vehicles, for example, and choose a loan from a bank or credit union as they are more credible.  

Revolving credit refers to loans that have a specific borrowing limit and the borrower is able to make charged up to that limit. If the loan is repaid, then the person is able to make charges again up to that limit. A minimum payment needs to be made each month, but it's recommended that the person pay the full amount. If only a partial amount is paid, the remainder will be carried forward and more interest will be paid, this is otherwise known as a revolving debt. The most common type of revolving debt are credit cards. When used correctly, credit cards can positively impact a person’s credit score in the long term more so than other forms of credit. According to Bingham (2011), using a credit card smartly requires the cardholder to make a purchase with the card at least once a month, keep the account for as long as possible, pay at least the minimum payment on time every month, and limit the amount used on the card to less than 30% of the card’s maximum. Credit cards are not always great though, as the incorrect use of them can be one of the most devastating things that can happen to someone’s credit. Missing payments, having too many credit cards, and borrowing most of the credit limit can hurt credit scores (Bingham, 2011).

Open credit has no maximum, which means that people who have it are able to use whatever they need, but they have to pay it in full every month. The most common type of open credit are business credit cards and, to some extent, utilities. Business credit cards will, like regular credit cards, have a positive impact on someone’s credit score if they are used wisely and paid on time. The same goes for utilities, such as water and electricity. If someone fails to pay for these utilities on time, companies can place limits, charge late fees, interrupt services, and deny services.

How can I build credit?

Building credit is something that will take a long time, so it’s important to start building it before the time comes when you really need it. It takes a long time because creditors need to see that you have a history of effectively managing credit and making payments on time; this way, they will have confidence in your and will lend you credit. If someone has never used credit or has negative information on their credit report, then they are less likely to receive credit; if they do, the interest rates will be higher. 

Credit cards are one way to build credit successfully, if used correctly. You could open a credit card account with a low spending limit or, if you have no credit history or a negative history, you might be able to get a secured credit card. A secured credit card is tied to a savings account and the limit is the amount on the account or a percentage of it. In addition, opening a joint credit card account or becoming an authorized user on someone else’s account can also help build credit. However, keeping the balance low and paying them on time is key to building credit. 

There are other ways to build credit without getting a credit card. Student loans are another way to do that; if paid on time, student loans can help you build your credit. Similarly, auto installment loans can be quite easy to get, even with little to no credit history, if you have someone who will serve as a cosigner with you. The amount they lend you and the interest rates depend on the bank or credit union you go to, but, depending on the situation, they will give you a loan for a car if you have a cosigner with a good credit history. If you make your payments on time for two years, the official assigned to your case might be able to release the cosigner. However, remember that failure to make payments on time will harm not only yours, but your co signer's credit as well. Other installment loans are mortgages and personal loans. 

Additionally, banks and credit unions can give someone a secured loan. These are low risk loans that have been designed for building credit that are similar to a secured credit card. Moreover, if you don’t want a credit card or a loan, you can ask utility companies to report your information to credit bureaus. Most utility companies don’t report unless you miss payments, but if you have a history of paying your bills on time then this demonstrates your money management skills and credibility; therefore, utility companies will be able to report this information that will help you build your credit. 

Remember that building credit from scratch and maintain it is a matter of time and being responsible with your payments. Never borrow or spend more than you can pay back because missing payments can be detrimental to your finances. A poor credit score on a credit report can hurt your chances of getting a favorable interest rate on your auto or mortgage loans; as well as your chances of getting any line of credit. Besides this, a negative credit score is not something that will be easy to restore. So it’s important to be wise about credit and to know what it is, how it works, and how you can maintain it; especially since it’s such a powerful tool for your finances

References:

Bingham, A. (2011). The road to 850 (2nd ed.). Layton, UT: CP Publishing

Experian. (2019). Retrieved from: https://www.experian.com/blogs/ask-experian/credit-

education/score-basics/what-is-a-good-credit-score/

Experian. (2019). Retrieved from: https://www.experian.com/blogs/ask-experian/credit- 

education/improving-credit/building-credit/

Kenton, W. (2019). Retrieved from: https://www.investopedia.com/terms/c/credit.asp

Martin & Memmott. (2014). Retrieved from: https://digitalcommons.usu.edu/cgi/viewcontent.

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