What is Credit and How Do I Earn it?
Dec 24, 2020
Ahhh, adulting. There’s so much fun and freedom in it, like having money to buy the things you want. But with that freedom comes the responsibility of managing your finances so you can achieve your shopping goals. And somewhere along the way, that means establishing and maintaining good credit over the long haul.
However, not everyone has a perfect credit track record (or one at all), especially when just starting out in adult life. One reason for this is that they get access to credit (usually, and too easily, through a credit card) without fully understanding how credit works, why it’s beneficial and how to manage it successfully.
We’re here to help with a little Credit 101, including tips on how you can earn credit and easily build it over time to hit the credit score you need. (You may be doing some of them already!)
The Definition of Credit: Building Trust
Building credit is much like cultivating trust in a relationship. If a friend asks if you can lend them something that you possess, with your permission they borrow it from you with the understanding and your trust in them that they will give it back to you. Lenders, merchants and service providers apply the same type of faith when you seek to obtain credit from them as a way to borrow money or access goods and services.
The reality is that some of life’s biggest purchases (like a house, a car or college tuition, even unexpected emergencies) are things most people can only buy on credit. For this reason, having a good credit history and credit score are of the utmost importance to lenders in determining your eligibility and trustworthiness for paying back your loans on time.1
Credit History and Credit Reports
The first step in a lender’s faith process is to look at your credit history your record of borrowing and repaying to determine whether or not to issue you credit and how much trust to place in you that you’ll pay it back.2
To do this, they look at your credit report, which is summarized and compiled by three independent credit bureaus: Experian, TransUnion and Equifax. Banks, credit unions, credit card issuers and other creditors report your borrowing and repayment history to the credit bureaus. The information on your report will typically include activity in the following areas:
The number of credit cards and loans you’ve taken out and how much you’ve repaid.
Whether you make payments on time, or if any were late or missed.
If you’ve had any mortgage foreclosures, car repossessions, bankruptcies or other major setbacks.
Your Credit Score
The information on your credit report determines your credit score which, again, is a reflection of how well you manage your financial responsibilities over time.1 This three-digit score distills the information on your credit reports in a nonsubjective way to something that’s easy to wrap your head around.
Credit scores generally range from 300 to 850,3 but here are the scores you want (of course, the higher the better) to have a shot at obtaining credit for purchases you want to make.
580 to 669 = Fair
670 to 739 = Good
740 to 799 = Very Good
800+ = Excellent
800+ = Excellent
Different models can calculate scores differently, but all of them naturally give higher scores to those whose credit histories make them statistically more creditworthy than those with lower scores.2 stance, the better your credit score, the less total interest you’ll be made to pay on a credit card or loan.1,3
So How Do You Build or Improve Credit? It’s Easier Than You May Think
Whether you’re just starting out with zero credit history, or you’ve hit a few bumps along the road and your credit score took a hit, there are ways of building that trust and getting back on the right track.1
Open a Credit Card
A credit card is a very useful type of credit tool that can help you build your credit when used wisely. However, that’s easier said than done; it’s easy to give into the temptation of using it for a purchase “just this once” without a sound plan to pay it off (which could be longer than you use the product you bought with it). When it comes to using a credit card, remember to keep your credit utilization, the percentage of your credit limit that you use, low. The lower your utilization, the better it is for your score.
Monitor Your Credit Report
Regularly taking a look at your credit report is important and … free! Besides the fact that monitoring your credit report is just a good habit, this practice will help you make sure it’s in good shape when it comes time to apply for new credit and allow you to monitor your progress over time. What’s more, your credit report plays a critical role in your credit transactions and other financial relationships. So, whether you’re trying to build your credit or maintain your good standing (read: everyone), this simple step is key. (All of the credit bureaus can easily walk you through how to obtain and understand your report.4)
Pay Recurring Bills on Time
Did you know that simply paying your bills every month (rent or mortgage, utilities, internet, cable, etc.) helps your credit score? It’s true: You’re building your credit history just by paying those types of bills on time and living your life. Making agreed-upon installment payments on loans for a car or house, a student loan or any kind of personal loan helps, too.
No one single avenue described above will help you build credit immediately, but a combination of ways can help you get there faster. And even a little effort adds up. Apply a little time, patience, discipline and creativity into your financial management, and the rewards will be huge.