What is Credit?
Credit is the ability to borrow money.
Lenders, also called creditors, are willing to lend because they expect to get their money back and make a profit. Different types of lenders – such as banks, investment companies, credit unions, and even the federal government – provide different types of credit.
You’re the borrower. You qualify for credit if lenders consider you creditworthy. That means lending to you isn’t too risky. When you borrow, you promise to repay the amount of money you use within a certain period of time, plus a fee for using the money. If you don’t meet your legal obligation to repay what you owe on time, you’ll pay penalties and face other problems.
The Impact of a Credit Score
Your FICO score does more than let potential lenders decide whether you’re a good or bad credit risk. Based on your score, creditors also determine your interest rate, which impacts your borrowing costs
FICO Score Components
While there are other credit scoring systems, FICO® is the most widely used measure of creditworthiness in the United States.
Your FICO score, which ranges from 300 to 850, is calculated using the information in your credit report. Although the formula is complex, there are five main components:
When you use credit wisely, you improve your FICO score. If you exhibit poor repayment behaviors, you’re putting your score at risk.
Why Use Credit?
Credit makes it convenient to buy practically anything you need or want without having the money in your pocket or in the bank. You can:
The Cost of Credit
For both revolving and installment credit, the cost of borrowing depends on the same factors:
Develop Smart Spending Habits
Often, you can get your debt under control by developing smart spending habits and making better choices with your money. Try taking the following steps:
There are times when simply adjusting your spending habits might not solve the problem. If you’re in serious debt, you might find that your financial situation requires an even bigger change.
With a credit card, the finance charge includes only interest. But with a loan, it also includes other costs, like application fees and checks on your creditworthiness.
The convenience of credit can make it easy to fall into debt. But if you’re able to recognize the warning signs, you may be able to avoid a serious problem and get your finances back on track. Watch out for these red flags:
If one or more of these situations rings a bell, it’s time to get a handle on your debt.
Types of Credit
Most people use two primary types of credit: credit cards and loans.
Credit with a Card
A credit card can be a handy way to borrow if you choose the right card and are smart about using it. Using credit this way doesn’t have to cost you a cent — provided the card has a grace period and you always pay the full amount you owe on time.
A grace period is the minimum of 21 days you have to pay your bill after the lender sends it to you. If you pay the whole thing in full by the day it’s due, there’s no finance charge.
But if there’s no grace period or if you pay only part of what you owe, using this type of credit will cost you money—potentially, big money. To figure your finance charge for the month, the lender multiplies 1/12th of your APR times your unpaid balance. That’s the interest you owe.
Avoidable Credit Card Fees and Charges
In addition to interest, there are avoidable credit card fees and charges that can add to your total cost of borrowing. Here are some to look out for—and to avoid.
There are times when a credit card isn’t the best kind of credit to use. For example, if you want to buy something that costs more than you have available on your credit line or that you can’t possibly pay off in a year or two, you can apply for a loan.
For example, you can use a loan to:
Some loans, such as car and home loans, are secured, which means if you don’t repay, the lender can repossess what you bought. Unsecured loans, including student loans, are backed only by your promise to pay what you owe. But repayment isn’t an option. It’s required.
Building a Credit History
Anytime you use credit, you’re adding a chapter to your credit history. All your credit transactions are recorded in a credit report, which is available to potential lenders who want to know how you’ve used credit in the past.
Your credit history includes all uses of credit—from student loans to everyday credit purchases—but not other payments, like the ones you make to the utility company or your landlord.
You’re assigned a credit score based on the details of your credit report. Your credit score is a snapshot of your creditworthiness, which lenders use to decide if you present a credit risk. The higher your credit score, the more creditworthy you are, and the more likely you are to receive credit.
Checking Your Credit Report
Protect yourself and your finances against identity theft. Below are some basic steps you can take. The Federal Trade Commission provides helpful tips for keeping your personal information secure.
Check your Credit Regularly
You have access to one free credit report each year from each of the three consumer credit reporting bureaus. You’ll want to monitor your credit report to ensure that no activity occurs on you account that you didn’t initiate.
The 3 Consumer Credit Reporting Bureaus:
Pro Tip: Set an appointment on your calendar at four month intervals to retrieve a credit report from the three credit reporting bureaus. This is the best way to track your credit history and know that your identity is safe.
Protect Your Personal Information
Identity thieves can use your personal identifying information to open accounts, apply for loans, apply for jobs, or commit crimes. Carefully guard your social security number, date of birth, address, bank account numbers, and your student ID number. Shred mail that contains any of these. Be conscious of where you are when you give your social security number over the phone. If others can overhear you, they can steal your information! It is also a good idea to review the personal information that you’ve included on your social media accounts.
Pro Tip: Be careful of entering your information online – only do so if you trust the site (look for the “https“). The “s” means “secure”.
Opening a New Line of Credit?
If you are thinking about applying for a credit card, make sure you understand the terms and conditions. Consult with a parent or someone you trust when you’re making the decision. Here are some questions to ask yourself:
Fixed Vs. Variable Interest
Interest rates can be “fixed” or “variable.” A fixed interest rate remains the same for the entire lifetime of your loan. Variable interest rates can shift (typically annually) based on market factors.
Simple Vs. Compound Interest
Some accounts pay simple interest, which only accumulates on the principal balance you deposited—not on any accrued interest that has previously capitalized. You’ll still earn money with simple interest, but it will take longer to earn the same amount as you would with compound interest.