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What Is Credit and Why Is It Important?

in Managing Money & Credit
What Is Credit and Why Is It Important?

Reap the benefits of establishing your credit early on.

I recently had a conversation with a 25-year-old about the importance of building credit. He has a good job and is able to save an admirable amount of money each month. He has life goals, which include purchasing a home in the near future. But, he has never taken out a loan and doesn’t have any credit history.

When I asked why, he stated that he feels apprehensive about applying for a credit card to build credit history because he’s heard from his parents (and other financial gurus) that credit cards are bad. Unfortunately, his apprehensions are not uncommon. This misnomer may lead one to not build credit history as early as possible, which in turn can cause lost financial opportunities down the road.

Some people believe that credit is a bad thing – something to be avoided. And although using credit must be done wisely, the notion that all credit is bad is misleading and untrue.

While debt can be bad, especially when coupled with high interest rates, credit is not inherently bad. Having a good credit rating is imperative for those who want to reach specific goals, such as becoming a homeowner, financing a vehicle, and even landing a good job. Having good credit affords many opportunities that otherwise would not be available.

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.

Types of Credit

There are three main types of credit that influence your credit history: revolving credit, installment credit, and service credit. Your creditworthiness is determined by the mix of the types of credit you use, as this allows borrowers to assess your reliability in different ways. We cover each type of credit in more detail below.

Revolving Credit

Revolving credit is most often associated with credit cards, but can also apply to lines of credit attached to checking accounts or home equity lines of credit (HELOCs). Revolving credit means the lender assigns you a credit limit which is often based on your creditworthiness. The lender can increase or decrease your credit limit based on factors such as payment history.

As consumers pay down their balance each month, they can make further charges to that credit account up to the limit. If you’re working on building your credit history, it’s a best practice to pay off your balance in full each month, which also prevents you from going into debt.

Installment Credit

Installment credit is a loan for a specific amount of money that the borrower makes payments toward over time. Common types of installment credit include mortgage loans, vehicle loans, student loans, and other personal loans. The interest rates on installment credit are often fixed throughout the life of the loan, unlike interest rates on revolving credit, which can fluctuate.

Service Credit

There is no such thing as a no-risk investment. Investment scammers, however, will do their best to appeal to investors’ desires to make a lot of money without risking their initial investment. Licensed investment brokers are very transparent about the fact that all investments carry inherent risk.

Service credit is different from revolving credit and installment credit in that you’re borrowing money for utility services. Utility companies who provide electric, gas, water, or other services create contracts with you in the understanding that when they provide services, you’ll pay for those services at the end of the month after you’ve used them. This is why the payment history on your utility bills is included in your credit reports.

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.

Learn More at Lafayette Federal

Lafayette Federal Credit Union offers tools and resources to support the financial growth of its members. We work with our members to provide the education they need to succeed – whether it’s for credit building, homebuying, fraud prevention, and more.

Not a Lafayette Federal member yet? You can become a member by completing an online membership application.