What Is Credit?
Credit, in the sense of borrowing money, is your reputation with lenders for repaying your debts. There are many instances when credit comes in handy or may even be necessary. To manage your credit wisely, you need to understand what credit is, what credit reports are, how scores are generated, and why credit is useful.
What Is Credit?
Credit refers to borrowing: your ability to borrow, the amount you can borrow, and whether you make your payments. Credit scores tell lenders how likely you are to repay your loans, which helps them decide whether or not to approve your loan request and how much to charge.
Your credit score is made up from information about your borrowing history. Most of the information comes from your credit reports.
What Is a Credit Report?
Credit reports are a collection of information, including:
- Loans that you’ve used in the past (generally the past seven years, although there are exceptions)
- Loans that you’re currently using (including any unused lines of credit)
- How much you’ve borrowed
- Your required minimum monthly payments
- Your payment history—have you made late payments, or are you always on time?
- Public records such as bankruptcy or foreclosure
- Any loans in default or in collections. Defaulting occurs when you do not make payments on your loan after a set amount of time. Collections is when the lender sells your loan to a collection agency, who then works to recover the amount from you.
Your credit report is the master document that's behind your credit. Based on that information, lenders decide whether or not to offer you a loan.
When a lender wants to see your credit report or get your credit score, they request it from a credit bureau (also known as credit reporting agencies).
Under federal law, you are allowed to view your credit reports for free at least once per year.
Credit reporting agencies collect all of the information that appears in your credit report. They are information warehouses, but 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 distribute or sell that information when you apply for a loan, or when a request is made (such as an employer or landlord, who need 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, you'll have to work to fix them.
Credit bureaus store information on hundreds of thousands of consumers with all of their financial history listed. Credit scores are numbers generated by a computer program that reads through your credit reports. It looks for patterns, characteristics, and red flags in your history.
Based on what the program finds, it calculates a credit score. Scores are easy for lenders to interpret. For example, credit scores above 720 might get approved automatically; scores between 650 and 720 may receive higher interest rates; lower scores 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 there are several ways to see your score for free. Note that there is more than one credit score available, such as FICO or Vantage.
What Is Credit Used For?
Borrowing money: This is the most common use of credit scores.
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.
Employment: Some employers check your credit, although you need to give them permission to do so. Presumably, they’re trying to determine if you are responsible.
Utilities: To get services such as electricity or water, you might need to get a credit check. If that’s not possible (because you have not yet built up your credit) or you have bad credit, service providers often demand a larger security deposit.
Renting: Similar to utility companies, your next landlord might ask to pull your credit. Depending on the rental market, your credit could prevent you from renting or lead to a higher deposit.
How Is Credit Useful for Consumers?
If you want to buy a house, you might need to set aside hundreds of thousands of dollars in a savings account, and that’s not feasible for most people. A mortgage makes it possible to own and build equity in the home (equity is the fair market value of the home beyond the amount you owe).
Credit allows you to obtain auto loans, student loans, or loans for other high-value products and services you may not be able to purchase in one payment.
Credit scoring makes it less expensive to borrow because lenders can more or less automate lending decisions. What’s more, lenders don’t discriminate based on race or other characteristics of borrowers (credit scores are supposed to eliminate any discrimination), so lending is fair.