Personal Finance
What Is Credit and Why Should I Care About It?
Tell us if this sounds familiar: You need to manage your day-to-day expenses, but you also want to make progress toward your financial goals. While one isn’t always dependent on the other, credit can help you achieve both.
Credit is an essential part of your financial tool belt. It allows you to buy something you may want or need now and pay it off later. Establishing good credit also may help you qualify for better interest rates on loans and can help you strengthen your application for an apartment, for example. It is important to understand what credit is to use it wisely and ensure you don’t end up in deep debt.
With a solid understanding of credit, you’ll be better able to leverage it to achieve your financial goals. Ultimately, knowing what credit is, how it works, and how you can use it to your advantage can help you feel empowered. Let’s get started.
What is credit?
Credit gives you the ability to borrow money to spend on things you need or want and pay for them later or over time. Examples of credit include personal loans, mortgages, car loans, and credit cards (which may be one of the simplest to understand).
Credit cards provide you with access to a certain amount of credit money (known as your credit limit). When used thoughtfully, credit allows you to make big purchases you might not have been able to pay for out of pocket, like a car.
If you use your credit impulsively it can lead to excess debt, higher debt payments and interest rates, and a lower credit score, all of which can impact your ability to qualify for credit. Not to mention, it can negatively affect your finances in general and stress you out. That’s why it’s important to only use your credit on things you know you’ll be able to pay off.
How does credit work?
Your ability to access credit is largely determined by your credit history and credit report. Your credit report is a file containing the records of your financial behavior over the last 7 – 10 years. It includes some important details, such as:
- The number of current credit accounts you have and their spending limits
- The total amount of your existing balances, including credit card debt and loans
- The number of loans you’ve taken out
- Your payment history
The three main consumer credit bureaus — Equifax, Experian, and TransUnion — gather this information and use it to calculate your credit score.
Your credit score is a three-digit number used by companies to predict how likely you will be to pay a loan back on time.1 The higher your credit score, the better, since a higher credit score can unlock things like lower interest rates for loans. It also indicates to lenders and credit issuers that you can be trusted to pay them back. According to Experian, the average credit score is now 714 as of 2021. A credit score above 670 is generally considered good by FICO (Fair Isaac Corporation).2
What are the different types of credit?
There are three general categories of credit:
- Revolving credit
- Installment credit
- Service agreements
Let’s take a closer look at each.
Revolving credit
Revolving credit is a line of credit you can borrow from freely, up to your credit limit. The most common type of revolving credit account is a credit card.
Your ability to use your full credit limit depends on meeting your credit account’s minimum payment requirements and payment deadlines.
When you use revolving credit, you can:
- Pay your balance off in full
- Make the minimum payment (typically between 1% to 3% of your total balance)
If you don’t pay in full each month, your outstanding balance rolls over (or “revolves”) into the next billing cycle, which creates interest fees. That’s why we suggest trying to pay off your credit card balance every month, if you’re able.
Installment credit
Installment credit is a loan with a fixed interest rate and repayment schedule. Installment credit accounts include many loans, such as mortgages, auto loans, and personal loans.
Service agreements
Service agreements allow you to receive services now and pay for them later. Examples include: a home utility contract, cell phone service contract, or gym membership.
Most service accounts aren’t factored into your credit score. Some credit bureaus now allow you to self-report utility and cell phone payment records and put them toward your credit scores.
Why is credit important?
Establishing good credit (and a high credit score) is important for many reasons, including the ones below.
Credit may make it easier to get lower interest rates
Potential lenders consider repayment history and credit score when you take out a loan for a car or house, for example. If your score is good, you’re more likely to be approved at a lower interest rate. A lower interest rate means you pay less money over the life of the loan, which may save you thousands — even tens of thousands — of dollars.3
If your credit score is low or you have an unreliable payment history, you may have trouble qualifying for lower interest rates and affordable financing opportunities.
Credit may help your rental application get approved
Some landlords or rental companies review your credit history before approving your rental application.4 Your landlord wants to feel confident you can — and will — pay your rent on time each month.
Credit may affect your job search
A potential employer may pull your credit report before offering you a job. This is more likely if you’re pursuing a financial or management role because your employer will want to know you can manage money responsibly.5
What are the risks of using credit?
Using credit impulsively can hurt your credit score, setting you up for higher interest rates on future loans or preventing you from qualifying for credit in the future. Easy access to credit also means it’s easier to spend beyond your means. That could lead to elevated debt payments, which may be difficult to keep up with.
Long story short: it’s important to be careful when borrowing money and use credit responsibly in order to develop a positive relationship with credit long-term.