The Basics of Credit – What it is, why it’s so important
Credit Basics – What exactly is Credit?
Credit, in financial terms, is defined as:
- “A means of borrowing money from a person or company and returning it at a later date, usually with accrued interest charged on top of the initial sum borrowed.”
- “A privilege granted for the purpose of extending time to make payment on a debt.”
- “The promise to pay in the future in order to buy or borrow in the present. The right to defer payment of debt.”
- “An agreement in which a borrower receives something of value in exchange for a promise to repay the lender at a later date.”
- “Reputation for solvency and integrity entitling a person to be trusted in buying or borrowing.”
Aside from dictionary definitions of the word Credit, it could be described as simply the ability of an individual (or company) to borrow money (personal loans, business loans etc.), or obtain goods without having to pay the entire cost up front (such as an auto loan or mortgage for example). Usually if you are issued Credit, you will be required to repay the amount of money borrowed in a specific time frame, at an interest rate specified by your lender.
So what is Good Credit?
Good credit basically means you pay your bills on time, have at least a somewhat long credit history, carry a low balance (or no balance) on your credit cards, and that you do not appear to be financially overextended (borrowing more than you can afford). If this describes you, chances are a bank or lending institution would be confident in granting you the credit you are applying for, with generous repayment terms, and a reasonable interest rate. This is where your Credit Score comes in, see below.
How can I establish Credit?
Normally when someone with little or no credit history is applying for a loan, a co-signer is often needed. This is basically a person with a good credit history who will contractually “vouch” for the person applying for the loan, and will enter to a legally binding contract agreeing to pay for the loan if the main applicant can no longer pay for it. Many times the co-signer will be a parent or another family member or close friend with an established credit history.
As long as other areas of your credit are managed wisely in the mean time, once the credit is obtained, good credit will be established if the payments are made on time on a regular basis, for an extended period of time, or until the loan is paid in full. If starting out with an auto loan, making the payments on the loan for at least 2 years will get you well on your way to establishing a good credit history.
However, credit card companies are usually more lenient about granting credit to individuals with little or no credit history. A credit card is normally how credit is first established, and it’s a good starting point as long as you use it wisely. Check out our article on How to Establish Good Credit with a Credit Card.
All if this information (your open accounts, and loans, and your payment habits) will be included in your credit report.
What is a Credit Report?
A credit report contains vital information about your credit history. Including any loans and credit card accounts and balances, as well as the status on those accounts (i.e. pays as agreed, late, missed etc.). See our article on What is a Credit Report for more info.
What is a Credit Score?
A credit score is a statistical summary of the information contained in your credit report. It’s purpose is to summarize your credit worthiness in a simple 3 digit number which can be very quickly assessed by lenders. This number or “score” will often influence whether or not you receive the credit you are applying for, and if you are offered a competitive interest rate. However, it is not the only factor in determining your ability to repay a loan, lenders will usually look at your entire credit report as well before making their decision.
Your credit score can vary depending on which credit bureau you are checking (Trans Union, Equifax or Experian). Sometimes there is even a different credit score when applying for mortgages, than there is when applying for auto loans. Credit scores can range from 375 to 900 points, the higher your score the better. The average score is between 650 and 675, but generally anything above 700 is considered very good, whereas a score of 600 or below is usually perceived as low, and in need of improvement. See our Credit Score page for more detailed info.
How can I check my Credit Score?
Luckily in this day and age, it is really very simple to check your credit score online. Check out our article on How to get a totally free credit score for more information.
How can I improve my Credit Score?
If you have checked your free credit score, and you have decided that your credit score needs some improvement, take a minute and review some of the most common causes of a low credit score, ask yourself these questions:
- Have you filed for bankruptcy recently?
- After checking your credit report, do you have any late or missed payments, that have been reported?
- Any repossessions or foreclosures?
- Do you carry a high balance on your credit card(s)?
- Or possibly – Do you have no credit history at all?
Those are some of the things that will bring your credit score down the most. If you answered no to all the questions above, ask yourself these additional questions:
- Have you submitted several applications for new credit recently (credit cards, auto loans etc.)?
- Is your credit history reletively short?
- Do you only have credit cards, and no other credit accounts such as an auto loan or mortgage?
If you answered yes to any of the questions above, or if your credit score is below 700, you will definitely want read our section on how to improve your credit score.
Where to start
Whether you are trying to improve your credit score, or just entering into the credit world and need to establish a good credit history, obtaining your Free Credit Score is tops on the list.