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What is credit and why does it matter?

August 25, 202114 minute read

Your credit matters more than most people realize when applying for their first credit card or opening their first store account. Credit affects many things about your life — from where you live to where you work and even how much you pay for auto insurance.

Understanding the basics of credit can help you make important decisions about the type and amount of credit you need. Whether you’re just beginning your financial journey or you’re trying to rebuild your credit, this article will help you understand the good, the bad and the ugly about credit to spare you the pain of getting in over your head with credit.

What is credit?

In a consumer-based society, like the one we have in the U.S., credit is an essential fact of life. Whether you have a long and well-established credit history, a bad credit history or practically no credit history, your credit — or lack thereof — can have a profound impact on your quality of life and financial reality.

Without credit, you must pay cash for everything. Unfortunately, some things are too costly to pay cash upfront for — at least for the average person. Credit allows you to purchase the goods and services you need now and pay for them over time.

Without the ability to use a credit card or get a short-term loan, some of life’s little emergencies can become huge weights and massive financial burdens for you and your family. Good credit can help you weather these storms and go on to face the next challenges ahead of you.

If you plan to buy a home, purchase a car or rent an apartment in a desirable area, you need to have credit in your name. More importantly, you need to have good credit in your name to achieve these goals.

Why does credit matter?

The significance of credit is difficult to quantify. Your credit score is one of the most important numbers, financially speaking, for the average American adult. Seriously. Without good credit, you may have difficulty with the following:

  • Purchasing a home — A home is a major purchase. With average home prices on the rise, it’s unlikely you’ll be able to save enough to pay cash upfront for your home anytime soon. That means you’ll need to have a high enough credit score to qualify for a mortgage loan. Beyond that, though, your credit rating can also determine your interest rate, which ultimately determines how much you pay for your home in the long run.
  • Renting an apartment or home — Many landlords require a credit score as part of the application process and use that credit information to decide if they believe you can afford to make your monthly rent payments — or even if they believe you will make the payments.
  • Affording utility deposits — Utility deposits are becoming facts of life for consumers. If you have bad credit, though, those deposits may be higher than the same deposits for people who have good credit. Having good credit means you’ll pay less for security deposits and, in some cases, may pay nothing.
  • Qualifying for an auto or other loanQualifying for loans can be difficult, especially if the loan is one for which there’s no collateral to guarantee repayment. Good credit can make all the difference, allowing you to purchase the vehicle you want and not the one the lender is willing to finance for you.
  • Paying lower auto insurance rates — In some states, your auto insurance premiums may be determined, to some degree, by your credit score. The better your score, the lower your insurance rates.
  • Renting a car — It's possible to rent a car without a credit (not debit) card, but the deposits required for this privilege can be rather prohibitive. Yet, there are some moments in life when renting a car is almost a necessity. A good credit score can help you save a lot of money on the car rental process.
  • Getting hired for certain jobs — Some jobs require a favorable credit rating in order to obtain the appropriate security clearances, handle large sums of money or even manage people who handle valuable items. Some states have strict laws regulating the use of credit scores for employment, but some industries remain exempt from many of those requirements.
  • Purchasing cellphone service plans — Many mobile phone plans require good credit for a long-term plan. Although many companies offer prepaid options that are attractive, some users feel they sacrifice certain services or “perks” by going the prepaid route.
  • Managing emergencies — Your good credit can be instrumental in helping you manage emergencies and unexpected expenses, such as medical bills, vehicle repairs or the need to travel for a family emergency.
  • Securing a business loan — Although your business is a separate entity, the credit used to start a business is your personal credit. If you’ve always dreamed of owning your own business, the only way to make that happen is to begin with solid credit.

As you can see, your credit score affects nearly every aspect of your financial life. To a large extent, it can be instrumental in determining your quality of life as you age. That’s why it’s so important to begin early to establish positive credit habits and nurture a good credit score.

What is a credit score?

You’ve heard a lot of talk about good credit. But what does that really mean, and how do you know if you have it?

A credit score is a number used in the financial industry to indicate a person’s creditworthiness. The lowest score is 300, and the highest possible score is 850. The higher your credit score, the better your odds of being approved when applying for a loan — as long as you meet other minimal standards of the lending agency you’re working with.

Each lending institution has its own system of scoring credit, but the generally accepted credit score for good credit is between 670 and 739. A score of 740 to 799 is considered very good credit, and scores above 800 are considered excellent credit.

Although you’re much more than your credit score, this number is all many lenders will see about you when making credit decisions. If your credit score isn’t sufficiently high, you're likely to be turned down for standard credit offers and only have high-risk credit options available.

High-risk lenders often charge substantial fees and prohibitive interest rates and offer unfavorable terms for borrowers. It’s much better to take your time and establish good credit early than to fall into one of the many high-risk credit traps that are so abundant today.

How is credit calculated?

Each creditor has different requirements and formulas for determining whether it's willing to accept you as a credit risk. Creditors come to this determination based on a combination of your credit score from one of the major credit scoring agencies and requirements of their own.

There are two primary scoring models used to determine credit scores:

  • VantageScore
  • FICO (Fair Isaac Corp.)

How common are these two scores? The two of them combined determine approximately 20 billion credit scores each year, according to Experian. VantageScore is a relative newcomer to the industry as it has only been around since 2006. FICO is an older entity, originating in 1956, but it’s only been calculating credit scores since 1989.

Fortunately, these organizations do the math on your behalf, and you don’t have to pull off some heavy-duty calculations in order to determine your credit score. It’s a good idea to know what your credit score is, however. You can check that annually by getting a free copy of your credit report from the three credit reporting agencies:

  1. Experian
  2. Transunion
  3. Equifax

You can get all three reports from one source: If you prefer to check more often than once per year, you may do so, for a fee.

Good credit vs. bad credit

By now, you know good credit is better than bad credit if you want to pay lower interest rates and have access to some of the nicer creature comforts in life. What you may not understand is what you need to do to have good credit rather than bad credit.

What is good credit?

Good credit is, essentially, a credit score of 670 or greater. A score in this range gives you access to better interest rates than someone with fair credit. It may also give you access to financing options that are unavailable with lower interest rates.

Even government-backed home loans require a minimum credit score of 620 or greater. This is with sub-prime interest rates that cost buyers much more in the long run to achieve their dream of homeownership. It’s worth spending a substantial amount of time improving your credit score before applying for any major loan or financing.

What is bad credit?

Bad credit is what happens when you have too much debt, fail to pay your bills on time, go into account collections with various lenders, or experience foreclosures, evictions or bankruptcies.

There are three primary causes of bad credit. The first is ineffective money management. Even if you have the money to pay your bills each month, some people are regularly late on their payments, which results in negative credit marks, penalties and late fees.

The second is circumstances beyond your control. Sometimes the unthinkable happens. People lose jobs, they’re out of work for more than a year due to a pandemic or they have medical emergencies that place them in enormous debt. Life happens, and it can sometimes have a negative effect on your credit.

The third cause of bad credit is overextension. It’s easy to overextend yourself with credit. The idea of buying the things you want now and paying over time can be intoxicating — especially in a society where new $1,000 phones come out twice a year by every major brand.

The bottom line

There’s no denying the importance of credit in today’s modern society. Now that you understand what credit is, why it’s important, how it’s calculated, and the difference between good and bad credit, you’re well equipped to make better financial decisions.

It takes practice, diligence and self-control to manage your credit effectively. But the reward for doing so is a good credit score that allows you to purchase the things you need — and many of the things you want.

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