Credit can open the door to opportunities you wouldn’t otherwise be able to pursue—like going to college, buying a car, or financing your first (or second) home.
But, with great power comes great responsibility. Credit can empower you financially, but misusing it can also lead to serious problems.
Knowing how credit works—and what you can do to use it wisely—is key to avoiding credit pitfalls.
Here’s everything you need to know about how credit works and why it’s so important to build a credit history for yourself.
What is credit and why do you need it?
When you use credit, you essentially borrow money so you can buy something now, and you make a promise to pay for it later.
For example, you use credit when you take out a car loan—without the availability of financing, many people wouldn’t be able to afford a new vehicle.
Driving off in a new car not only feels good, but it also allows you to get to work, run errands, and socialize with friends. When you drive to work, you earn money, which in turn allows you to build your wealth over time.
Credit is also good for the economy—it allows people to purchase the things they need, which incentivizes businesses to make products and offer services. As companies produce, they make money and provide jobs to the community.
5 reasons credit is so important
Credit is important, but it’s even more important to focus on building good credit. When you’re careful about how you use credit, you can safeguard your lifestyle and feel confident about the future.
Here are five reasons why credit is important:
1. Establishing a credit history
When you lack a credit history—meaning, you’ve either never used credit or your credit use has gone stale—lenders and creditors don’t know what kind of risk you pose.
When banks can’t tell if you’re responsible and reliable, they can’t be certain you’ll pay your bills on time. This can stop you from getting loans, or force you to pay higher interest rates on the loans you do get.
2. Help in emergencies
Credit can also be a lifesaver in an emergency, such as a flood, fire, or unexpected car repair.
It’s always best to build an emergency fund you can pull from when you need it, but not everyone has the budget to stash money away.
If you have a credit card, however, you can rely on it for quick access to cash.
3. Theft protection
One of the golden rules of travel is “leave your cash at home.”
With a credit card, you can quickly and easily freeze your account if your wallet or purse is stolen or misplaced.
You can’t say the same for cash. Once that hundred-dollar bill is lost, it’s lost—and there goes your souvenir buying plan.
4. Perks and rewards
Credit card companies want to attract customers, and many do this by offering incentives like hotel discounts, frequent flyer miles, rebates, and cashback bonuses.
As long as you are paying off your balances in full every month (and not paying interest), you can actually make money off of the credit card companies!
5. Renting a car
Many rental car companies require you to use a credit card before they’ll give you a car—this can be a nasty surprise if you try to travel without access to credit.
What is a good credit score?
There’s more than one game in town when it comes to calculating credit scores, but a good rule of thumb for defining a very good score is anything 750 and above.
Here’s how Experian breaks down the different FICO score ranges:
|FICO Score||Rating||% of People|
How credit scores work
While FICO is the dominant player in the world of credit scores, many lenders also use VantageScore. Regardless of which methodology is used, your credit score is made up of five factors—each of which carries its own weight in your overall score.
- Payment History (35%). Whether you pay your bills on time.
- Credit Utilization (30%). How much credit you’ve used compared to how much available credit you have.
- Credit History (15%). How long you’ve been using credit.
- Credit Mix (10%). The various types of credit you have. It’s better to have a variety rather than too much of one specific type.
- New Credit (10%). How many new accounts you have.
While each factor is important, your payment history dictates 35 percent of your score—if you’re late on even just a few payments, it can really cause your credit score to take a hit!
5 quick tips to build credit (without taking on debt)
If your credit score is a reflection of how well you use credit, don’t you need a bunch of credit cards and loans to prove your worth to lenders?
You don’t need to carry a bunch of debt to have a healthy credit score—there are a few tried and true methods for boosting your score without incurring any additional debt.
Here are five options to consider:
1. Get a secured credit card
Secured credit cards are great if you lack a credit history, or if you are working to repair a bad credit score.
With a secured credit card, you put down a small amount of cash, which is typically also your credit limit. If you miss your payments, the credit card company can keep your down payment.
There are many different secured credit cards on the market today, and deposit amounts vary. You can expect to pay anywhere between $50 and a few hundred dollars, although some cards have higher deposit amounts.
As with a bicycle with training wheels, the goal of a secured credit card is to build up your creditworthiness enough to graduate to an unsecured credit card.
2. Get a credit builder loan
A credit builder loan is another great way to dip your toe in the credit waters—these loans, like the ones from Self Lender, come in relatively small amounts of money, which the lender holds while you make your payments.
The lender also reports your payments to the credit bureaus, so you establish both credit history and a record of timely payments. Once you’ve paid off your loan, you receive the cash.
3. Ask someone to co-sign
If you can’t qualify for a loan yourself, you might be able to get one with a co-signer.
For example, a parent might agree to co-sign a loan for a new car—this allows you to purchase a new vehicle, build your credit, and possibly get a lower interest rate.
But it’s important for your co-signer to understand the risks—if you default on the loan, the lender will come after the co-signer for the balance.
4. Become an authorized user
If you know someone who has good credit, why not piggyback on it?
Many accounts, such as credit cards, allow a borrower to add someone as an authorized user—this means you get the privilege of using the credit card without being obligated to pay the bill if the account owner defaults.
Important note: If a parent or other relative adds you to their account, make sure the creditor reports your payments to the credit bureaus.
5. Enroll in a rent-tracking service
If you rent an apartment, you can sometimes use your rental payments as a credit-building tool.
While most landlords don’t report their tenants’ payments to the credit bureaus, you can sign up for rent tracking services that will track your payments and report them to the credit bureaus.
5 good credit habits to stick by
It’s important not to fall into the trap of using credit before you understand why good credit habits are so important.
For example, you might open credit cards as a college student, and run up large balances that sink your score for years.
If you’ve worked hard to clean up past credit mistakes, you’ll want to stick to good credit habits to help maintain your score going forward.
1. Make your payments on time
Your payment history makes up 35 percent of your credit score. You may find enrolling in automatic bill pay helps you stay on top of payment due dates, so you don’t get dinged by late payments.
2. Keep your credit utilization low
Avoid taking on too much debt compared to your total amount of available credit. To lower your credit utilization, tackle one account at a time and pay it down. For example, focus on a credit card by paying more than the required minimum payment. If you can keep this up for a few months, you can improve your credit utilization and end up paying less interest.
3. Keep your balances low
Don’t allow the balances on your credit cards to creep up—this puts you in danger of maxing out your available credit, which makes you a higher risk to lenders.
4. Don’t close old accounts
When you work hard to pay off a credit card, you might be tempted to cut up the card and close the account. But this can end up hurting your credit score by shortening your credit history and shrinking your available credit. If you pay off a credit card, don’t close the account—even if you never use it.
5. Have a healthy mix of credit types
Your credit use should look like a buffet, with a good sampling of credit types in the mix. Try to aim for a blend of credit cards, a mortgage, car loans, student loans, and other credit types—this demonstrates to lenders that you can handle different kinds of financial obligations.
What are the risks of using credit?
Credit is a good thing if you know how to use it properly, but it’s not without risk.
When you misuse credit, you can put yourself in a financial bind for years, which can have a ripple effect on many areas of your life, from paying for a child’s college tuition to planning for retirement.
The allure of credit can also prompt you to reach higher than your budget allows.
If you use credit to buy things you can’t really afford, you can set yourself on a hamster wheel of playing constant catch-up with your bills. In some cases, you simply can’t keep up, and you may be forced to file bankruptcy.
Using credit wisely
Credit opens up opportunities, but it can also lead to long-term financial challenges if you abuse it.
Worse, it doesn’t take long for negative items on your credit report to pile up, sending your score plummeting.
Understanding how credit works and which factors influence your score can help you avoid credit mistakes.