Credit often feels like a mysterious and treacherous aspect of personal finance when you are young and/or just beginning your money management journey. Despite its reputation, credit is a tool that with responsible use will improve your financial standing. Before you embark on the journey of seeking credit, it is important to know how credit and credit scores work so you don’t accidentally end up in hot financial water.
So what is credit? Credit is money you borrow to use for goods and service and that you will repay at an agreed-upon time with any applicable fees and charges (usually interest). There are four types of credit.
- Revolving
- Charge
- Service
- Installment.
Revolving credit is typically associated with credit cards. When you use this type of credit, the lending institution approves you for a maximum amount of credit, also known as a credit limit. Every month, you make a payment to your lender. Ideally, you should pay your balance in full. When you carry a balance from month to month, the lender will charge interest to the balance on your card. This increases the amount you pay to own the item(s).
If you buy things on sale but can’t pay them off immediately, the interest charges mean you didn’t save any money when you bought those sale items. In fact, you will likely spend more on the item(s) than it was worth to begin with. This is an easy way to wind up buried in debt. When using a credit card, never spend more than you can afford to repay on your monthly bill.
Charge cards are similar to credit cards. Instead of carrying a revolving debt with interest charges, you are required to pay the balance in full every month. Although there are some annual fees, there is no interest or credit limit. Only consumers with high credit ratings qualify for these accounts. My parents use this type of credit to finance business expenses for their micro-brewery.
If you pay your own phone, internet, or gym membership, you actually already use service credit. With these accounts, you receive services with the agreement (usually in a contract) that you will pay for them when you receive a bill every month. Not all service accounts show up on your credit history, but major ones, like utility bills or rent, generally do.
Installment credit accounts are usually taken out through a bank or credit union. Car loans and mortgages are two common types of installment credit loans. The creditor lends you a specific amount of money, called the principal, and you pay it back in installments (A.K.A. your monthly payment) over an agreed on time-frame and normally with interest. Small vehicle loans can be a good way to build up credit.
When you open any type of credit account, it is added to your credit report. There are several account designations that credit bureaus use to calculate your credit score. Credit bureaus track your balance and payment history for each account. They record which accounts are paid properly, which are delinquent (past due payments; potential negative impact) and which are derogatory (long-lasting negative impact often resulting from bankruptcy, foreclosure, and tax liens).
Your credit score is a numerical ranking that represents how reliably you repay money; the higher the score, the more trustworthy you are as a borrower. To maintain a good score, or repair a poor one, the best practice is to pay all your bills on time. If you carry a high debt load, especially on a credit card, it is in your best interest to pay that off as soon as possible.
Repairing a poor score takes time because there is no way to erase credit history. The longer you go without missing payments or generating more debt the old history will be less relevant and your score will begin to rise.
It is also important to check your credit score two or three times a year. It costs nothing and can help reveal fraudulent activity. You are entitled to one free report every year from each credit bureau: Experian, TransUnion, and Equifax. (Click here for contact information.) You can also do a soft check with Credit Karma.
When beginning to use credit, it can certainly be an intimidating prospect. However, with responsible use you can build a strong credit score and improve your quality of life. Your credit score is used to evaluate how good a candidate you are for renting properties, qualifying for loans, and obtaining good interest rates in the future. Just make sure that any credit you decide to use fits within your budget.
Written by Mckenzie Candalot, Staff Writer – Mckenzie Candalot graduated from the College of Idaho with a B.A. in English Literature. She has a passion for written language and helping other women take control of their finances. When not blogging or reading, she enjoys cooking and spending time with loved ones.
