What is Credit, and Why Do I Need It?

If you’ve ever wanted to borrow something, be it a tool from a neighbor or money to buy a house, you need to have some sort of credit.

While your neighbor may simply decide whether or not they trust you with their tools before making the decision, a bank is going to want something more concrete to judge your worthiness.

Let’s talk credit.

What is credit?

In a sense, credit is a measure of trust. But most often, it refers to money that you’re borrowing with the promise to pay back.

You can use credit to buy just about anything. Without it, you wouldn’t be able to get a loan for big purchases, like a car or house.

For most people, the easiest way to use credit is to use a credit card. A credit card allows you to make purchases with borrowed money, and pay it back at a later time, with interest added.

What is a credit score, and what’s my credit history?

Your credit history is the sum of all the transactions that have been reported to credit bureaus in your name over the years. These are all recorded in your credit reports, which are sourced from three companies, TransUnion, Equifax, and Experian.

Your credit score, on the other hand, is a numerical grade that is based on your credit history. Think of it like a grade you’d get in school — an A is good, and an F is bad. Your credit score is a number between 300 and 850, and the higher, the better.

A score of 700 or better generally means you have good credit.

Building credit

If your credit score is low or you’ve never borrowed money before, you’ll want to start building credit and a credit history. When you have a history of taking on debt and paying it back on time, lenders can see that you’re trustworthy, and will be willing to lend you more and on more favorable terms.

That doesn’t mean that you should get your hands on a credit card and on a wild spending spree and or take out a loan to buy a BMW.

Instead, try one of these responsible ways to start building credit:

  • Get a secured credit card – You can get a secured card with a small deposit and a reasonable credit limit, typically between $200-$800. This is like having a credit card with training wheels, and won’t allow you to get into too much trouble.
  • Find a co-signer – This is basically piggybacking on someone else’s credit, like a parent. Someone with an established credit history can jump on a line of credit with you, giving the lender confidence they’ll be paid back.
  • Sign up for a retail credit card – Store cards usually have lower credit limits, and like a secured card, can have natural guard rails for newbies. Gas station cards can work particularly well if you drive regularly, as you can also earn rewards.

What to watch out for

The biggest danger with building credit is getting in over your head. You want to take on debt, of course, to prove you can pay it back, but you don’t want to find yourself suddenly neck-deep in capital quicksand. Avoid these pitfalls which can easily set you back:

  • High interest rates – Average annual percentage rates for credit cards is between 12% and 15%, according to industry data. But if you have little or no credit, lenders will want to charge you way more. Be aware of your card’s APR, or shop around for a lower rate.
  • Credit dings – You can hurt your credit score by applying for multiple credit cards or loans. So, cool your jets, or you’ll shoot yourself in the foot.
  • Going too deep – Just because you can spend, doesn’t mean you should. Don’t max out your credit card by reaching your credit limit. Again, this will keep you from going too deep into debt, and also shows lenders that you can exhibit some self control and moderate your spending.

Be patient

Money doesn’t grow on trees, and even if it did, it would take a while.

The same logic applies to building your credit. It’s going to take time. And it’s better to start sooner rather than later. Your credit history and credit report will influence lenders’ decisions about your creditworthiness, and the more they have to work with, the better.

Remember to live within your means, don’t spend more than you can afford to pay back, and make regular payments, and you’ll be in good shape.

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