Understanding Personal Credit: What It Is, What It Affects, and How to Build It
Your credit can affect a variety of things, ranging from loan approvals to landing a job or promotion. This guide aims to help you better understand common credit terms, what your credit can impact, and ways to actively improve your credit.
Section 1: Credit History, Credit Reports, and Credit Scores: What Are They?
When speaking about credit, there are many terms that get thrown around and often used interchangeably. This section explains three important credit terms that everyone should know: Credit History, Credit Reports, and Credit Scores.
Your credit history refers to how you have previously conducted yourself as a borrower. Potential lenders use your credit history to judge your trustworthiness, reliability, and the likelihood you will pay back what you owe. A long history of making on-time and full payments indicates to lenders that you are a reliable borrower. On the other hand, having a history marred by late payments and maxed-out credit cards will make lenders wary of you.
Lenders will use your credit history to decide whether to give you credit, and the terms on which they give it to you. For example, if you have a bad credit history, the interest rates you would pay on a loan will be higher than if you had a good credit history. If you have a terrible credit history, lenders may not approve you for credit at all.
Your credit reports are records of your financial history which contain information about your credit accounts, such as your credit cards, loans, and other financial products. These reports contain both positive and negative behavior regarding your credit accounts. You do not just have one credit report. There are three major credit bureaus that produce credit reports, namely Equifax, Experian, and TransUnion. Each of these bureaus has a separate credit report for you, though the information contained within all reports will usually be similar. Slight variances can occur in your credit reports as some lenders you deal with may not report to all three major bureaus.
The information in your credit reports is used to calculate your credit scores. A credit score is a number that indicates your reliability or risk as a borrower. It’s a measure of how much potential lenders should trust you to make back payments. The higher your credit scores, the more likely lenders will want to do business with you. Higher credit scores will mean you are more likely to be approved for credit cards and loans, as well as receiving better terms such as lower interest rates.
Similarly to credit reports, you do not have just one credit score but several. There are different brands of credit scores (the most well-known brand being FICO), and even these brands have different credit scoring models for different purposes. For example, if you are applying for a mortgage, a bank may use a different type of credit score than if you were applying for a credit card. Therefore, depending on the brand of credit score and the model, there may be slight variances in your credit scores.
Section 2: What Can My Credit History Affect?
A wide range of companies use your credit to determine how reliable you are to pay the money back and meet your obligations. Companies will likely use your credit history to decide if they want to do business with you and on what terms. For example, when you apply for a loan or credit card, the lender will check your credit reports and scores to determine whether they will approve you. If you are approved, the lender will also look at your credit reports and scores to determine the terms of the agreement, such as the interest rate and loan amount.
Credit cards and loans aren’t the only things that are affected by your credit. Your credit can affect a wide range of things such as:
- Being approved for a credit card
- Being approved for a mortgage, car loan, or other types of loans
- The interest rates on credit cards, mortgage, or other types of loans
- Renting an apartment
- Finding insurance coverage and the cost of your premium
- Getting a cell phone plan
- Opening a new utility account
- Getting certain jobs or promotions; in some states, employers are legally allowed to use the information on your credit reports
Section 3: How to Build Your Credit
If you want to start building your credit, there are several ways to do so. However, it needs to be understood that building great credit takes both time and responsibility. Ideally, you should start instilling good long-term habits regarding credit and your financial health, such as paying your bills in full and on time and keeping your credit card balances low. Here are three ways to start building your credit.
Responsible Credit Card Use
A credit card can be a completely free way to build your credit. However, in order to build your credit successfully with a credit card, you must practice responsible credit card use. Credit cards are serious financial tools. Misuse can leave you with expensive debt due to high interest rates, and damage your financial health long-term. In order to build credit with a credit card:
- Pay your credit card bill in full and on time every month.
- Only spend what you can afford to pay back when your bill is due.
- Keep your credit utilization low (credit utilization is the ratio between your total credit card balance and your total credit limit).
Credit cards with the best rewards and benefits generally require you to have high credit scores in order to be approved. If you have bad or no credit, credit card providers may not be willing to issue you a regular credit card. In this case, look into a secured credit card.
A secured credit card requires you to make a deposit to establish your credit limit. For example, if you give a $200 deposit to the credit card provider, your credit limit will be $200 in most cases. If you don’t pay your credit card bill, the card provider will keep your deposit. A secured credit card is a good starting point in your path to building credit. Once you have built sufficient credit to be approved for a regular unsecured credit card, you can get your deposit back by closing the card. Certain issuers will even convert your credit card account into a regular account if you have proven yourself to be a responsible cardholder.
Credit Builder Loans
A credit builder loan can be a fantastic start on the path to building credit. Credit builder loans are one of the simplest and safest ways to build credit, especially when a person has a history of bad or no credit. It is a type of installment loan where you pay the same amount monthly. Positive activity is reported to the credit bureaus as you pay back the loan. Upon paying off the entire loan, the funds will then be made available back to you.
Even if you have established credit, a credit builder loan can help bolster your credit scores further by adding variety to your credit reports.
Becoming an Authorized User
Being an authorized user involves someone else (such as a family member or a friend) adding you to his or her account so you get a card in your name. You can use the card as if it were your own, but you are not the primary holder of the account. An authorized user is not legally bound to pay the credit card bill or any debts that build up. This is the primary account holder’s responsibility.
Becoming an authorized user on a friend’s or family member’s credit card account can help you establish your credit history. If you know a person with good credit (and you both mutually trust each other), you can ask to become an authorized user on their credit card account. The accounts you are an authorized user on will likely show up on your credit reports. However, before becoming an authorized user have the primary account holder check whether the credit card provider reports authorized user accounts to the major credit scoring bureaus.
Becoming an authorized user does not require a credit check. If you have bad or no credit, you will likely still be able to become an authorized user and start building your credit, unless you have a negative history with the specific credit card issuer. You can also be added as an authorized user and have the primary cardholder hold on to the authorized card. The account activity will still be reported in your name, as long as the card issuer reports authorized users to the credit bureaus. However, there are also downsides involved when becoming an authorized user. Delinquencies from the primary cardholder, even a single late payment, will show up on an authorized user’s credit report and can have a severe negative impact on your credit. Tension can also arise if the authorized user acts irresponsibly with their card as the primary cardholder is still liable for the bill and any debt.
Understanding your credit and what it can affect can be confusing, but it doesn’t have to be. If you are at the start of your journey to building great credit, start with the basics. Understand the common terminology surrounding credit, and understand what your credit can affect. Once you have done this you can start trying to build your credit in a responsible and informed manner. While it may take time and perseverance, great scores can bring a number of advantages to both your personal and financial life.