Credit refers to your borrowing capacity. It's based on your history of paying back your debts, and it defines how much you are able to borrow cash or access goods and services.
There are many instances when your credit can make or break important transactions. To manage your credit wisely, you have to understand what credit is, what credit reports include, how scores are generated, and why credit is important.
What Is Credit?
Credit reflects your reputation for repaying your debts based on your record for borrowing and repaying funds. If you have a reliable borrowing record or credit history, you are said to have "good credit."
Good credit signals to lenders that you are "creditworthy" or likely to be able to repay money you borrow. It instills confidence in lenders that they will get the loan principal plus any interest back from you, which makes you more likely to get approved for new credit (for example, a loan) with favorable terms such as low interest rates or higher limits.
In contrast, if your credit history suggests to lenders that you cannot repay your debts, you are said to have poor credit. Having poor credit can hurt you when you apply for a loan because lenders will have less confidence that you can repay it.
How Credit Works
Credit is something you build up over time as you borrow money and pay it back. These records are tracked by the three major credit bureaus and available to lenders in the form of your credit report and credit score.
When a lender wants to see your credit report or get your credit score, they request it from what is known as a credit bureau (also called a credit-reporting agency).
Credit bureaus collect all the information that appears in your credit report from banks, card issuers, and other creditors, which voluntarily report your payment information. But even though credit bureaus store financial data on millions of consumers, they might not keep as much data as you think. For example, your annual income is not part of your basic credit report.
Reporting agencies then distribute or sell that information when you apply for a loan, or when a request is made (for example, by an employer who needs your permission before a report can be released). There are numerous credit bureaus, but the "big three" (TransUnion, Equifax, and Experian) have the greatest impact on your credit. It's essential that the information in each credit bureau is accurate.
If there are errors in your credit reports, contact the relevant bureau that generated the report to fix the errors and ensure that you don't get rejected for new credit needlessly.
Your credit report is the master document behind your credit, and each credit bureau issues one. Credit reports summarize various aspects of your credit history for up to seven years, including:
- Loans you took out in the past
- Loans you’re currently using (including any unused lines of credit)
- How much you’ve borrowed
- Your required minimum monthly payments
- Your payment history (for example, have you made late payments, or are you always on time?)
- Public records, such as bankruptcies or property foreclosures
- Any loans in default or in collections
- Credit inquiries for the past two years
Credit reports are important because they serve as the raw data for the credit scores that lenders use to assess your creditworthiness and decide whether to offer you a loan. Apart from your score, lenders take specific information in your credit reports into account when making lending decisions. You can and should review your own credit reports to identify issues before you apply for a loan. Under federal law, you can get a free copy of your credit reports once a year.
Checking your annual credit reports results in a "soft" credit inquiry, which doesn't hurt (or help) your credit score.
As the first step in deciding whether or not to grant you credit, lenders often use what are known as credit scores. These are three-digit scores generated by a computer program that reads through your credit reports and looks for patterns, characteristics, and red flags in your history and boils it down to an easy-to-interpret numerical format.
Different scoring models (FICO Score and VantageScore, for example) calculate credit scores differently and assess scores on different ranges. The FICO model, for example, considers your payment history, credit history length, total debt, new credit accounts, and types of credit accounts.
Regardless of the scoring model, lenders can interpret and make lending decisions based on your credit score in a similar way. This is because a higher score generally translates to a more creditworthy borrower while a lower score reflects a borrower with a lackluster borrowing history.
But lenders may have different standards as to what credit score is acceptable for credit approval. For example, a lender might automatically approve individuals with a FICO score of 740, while scores between 670 and 739 may put borrowers on the hook for higher interest rates, and those with scores lower than 580 may not receive approval.
While federal law gives you free credit reports, it does not guarantee free credit scores. However, you can buy credit scores from credit bureaus, and some card issuers provide access to credit-scoring services that allow you to see your credit score for free.
What Is Credit Used For?
Credit is important to consumers for two key reasons.
Credit Enables Financial Fulfillment
Your credit can dictate your ability to meet major life objectives, including:
- Getting a loan: This is the most common use of credit scores. It's not feasible for most people to save up enough to buy a house outright, for example. A mortgage makes it possible to own and build equity in the home (the fair market value of the home beyond the amount you owe) without becoming cash poor. Credit also allows you to obtain auto loans, student loans, or loans for other expensive products and services,
- Buying insurance coverage: Insurers check your credit to determine whether or not to cover you, and at what rates. They use insurance scores that are slightly different from standard lending scores.
- Securing employment: Some employers check a modified version of your credit report, including information such as your payment history, to determine whether you are responsible or would pose a risk to the organization. However, you need to give them permission to do so.
- Obtaining utilities: To get services such as electricity or water, you might need to get a credit check. If you have not yet built up your credit or you have bad credit, service providers often demand a security deposit.
- Getting a rental: Similar to utility companies, your next landlord might ask to pull your credit. Depending on the market, your credit could prevent you from renting.
Credit Encourages Fair Lending
Credit scores are also used to prevent lenders from discriminating against borrowers based on race or other characteristics. These scores are meant to give an objective representation of your credit history. While they may seem to present a barrier to getting a loan, the ultimate goal of credit scores is actually to make the lending process fairer for borrowers.
Credit scoring doesn't perfectly erase inequities in lending, as many studies have shown. There is still work to be done to make the system more objective.
How to Get Credit
If you don't have a history of borrowing, it can be a bit of a challenge to begin building your credit. You'll need to have a job and you may have to open a credit card with a co-signer who has established credit. Other options include secured credit cards (which require a deposit), store credit cards, and student credit cards. As soon as you have your name attached to a loan or credit card, credit agencies will begin building your credit report. If you use your credit responsibly, over time, you'll gain access to more of it.
- Credit refers to your ability to borrow and pay back money to lenders.
- Your access to credit is dependent on your borrowing and payment history, which is reflected in your credit report.
- You can build your credit over time by being responsible with the credit you have.
- Good credit makes it easier for you to move toward your financial goals.