When most people hear the word credit, they automatically think of a credit card. While the two are certainly related, credit encompasses much more than a rectangular piece of plastic. So what is credit exactly? More importantly, how does credit impact your finances?
Credit has serval different definitions and applications in the world of finance, but as it relates to your personal finances, there are two primary definitions of credit to keep in mind:
Borrowing money under an agreement that you will pay back the money you borrowed plus interest, the fee to actually borrow that money in the first place
Based on your past financial record, the risk of someone lending you money along with your overall level of trustworthiness as a borrower to pay back what you have borrowed
In short, credit refers to buying goods or services by borrowing money that you don’t actually have now but agree to pay back later as well as how likely you are to fulfill your responsibilities and obligations as a borrower.
Despite the bad reputation that credit sometimes has, the ability to utilize credit in your personal finances is a necessity for many individuals. Expensive purchases, such as a new car, buying a house, or getting a college education, often require the use of credit. Unpredictable events and emergencies that you aren’t able to plan for might cause someone to rely on credit. The bottom line is, when used responsibly, credit can be a very useful tool to have at your disposal.
To ensure that you are setting yourself up for success regarding credit, you may want to keep these considerations in mind:
Establishing credit takes time: If you are new to credit, know that after opening a line of credit with a financial servicer or institution, it will take 6 months for the established line of credit to reflect in your financial history. Additionally, improving your credit also doesn’t happen overnight- depending on your current credit history and your credit goals, it could take anywhere from 3 months to 7 years for you to see the desired changes in your credit.
Quality is better than quantity: It may seem like a good idea, but if you are trying to establish or improve your credit, opening multiple lines of credit at once won’t actually improve your credit or boost credit score. In fact, it may actually hurt your overall credit. Start out small with one account until you feel comfortable using credit, then periodically open a new line of credit. According to Experian, one of the three credit reporting bureaus, having 5 lines of credit responsibly maintained is ideal.
Credit is checked for more reasons than you think: It may not come as a surprise to hear that credit is checked before buying a home- with a majority of Americans relying on a home loan or mortgage, a bank or credit union will perform a credit check to see how big of a risk it is to let someone borrow money, especially considering how much will need to be borrowed with such an expensive purchase. But did you know that your credit will most likely get checked when you go to rent an apartment? Or when you decide to purchase internet or energy for your home? Potential employers can also check your credit and some may use it to determine your quality as an applicant. Even with access to large amounts of cash, having bad or no credit at all could keep you from purchasing certain goods or services.
When used responsibly, credit can provide an individual with more financial freedom. Good credit history might mean you can take out a loan without having to find a co-signer or that you can borrow money at lower, more favorable interest rates.
For many people, credit is established through a credit card, a lease on a car, or a student loan in repayment. If you are looking to establish credit for the first time, you might consider talking with your banking institution to explore the best options for you. Not able to meet with a bank or credit union representative? Check out the Card Comparison tool offered by Lending Tree to find a credit card that might be right for you.
Once your credit is established, be sure to take the proper steps to protect it. That means checking your credit report and monitoring your credit score. Read below for additional information on credit reports and scores.