Credit allows you to borrow money to access money, goods, or services, with the expectation that you’ll later pay back the amount you borrowed. This could come in handy if you want to make a purchase that you can’t immediately pay for, such as taking out a mortgage to buy a home or an auto loan to cover your car purchase.
However, credit is only extended based on the lender’s confidence that the borrower will repay them. Those who have good credit are viewed as more likely to fulfill their debt obligations, and thus are more likely to get approved for credit opportunities and secure better terms. This is why building and improving credit is important — it can open up doors in your financial future.
What Is Credit?
The meaning of credit boils down to a contractual agreement: If a lump sum of money or something of value is borrowed, the borrower agrees to pay it back in full at a later date, along with any applicable fees and interest. Credit can take a number of different forms, from a credit card to a mortgage to an auto loan to student loans.
When you have good credit, that means you’ve established a track record of paying your debt on time and within the agreed-upon conditions. If you’re deemed creditworthy, meaning less of a risk to lenders, you’ll have an easier time in the future borrowing money, at more favorable terms and rates.
On the flipside, if you’ve had trouble paying back money you borrowed or staying on top of payments, you’ll have a not-so-great credit score. In turn, lenders, creditors, and merchants will be less inclined to loan you money or extend a line of credit due to your higher perceived credit risk.
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Why Do You Need Credit?
In an ideal world, you’d have all the cash on hand needed to get those big-ticket items, like a house or a new car, or to fund your child’s college education. But in reality, you might need to borrow money to make those purchases, which is where credit can come into play.
Credit can help you reach your long-term goals and lead to greater opportunities. For instance, a student loan can help you obtain a higher education, which can be your ticket to higher-paying jobs. Or a mortgage could make it possible for you to become a homeowner.
Additionally, credit can offer various protections and perks that you might not get with other payment methods. For instance, with a credit card, you can enjoy benefits like purchase protection and also earn rewards on your purchases. When you apply for a credit card with SoFi and get approved for instance, you can earn cash-back rewards on all eligible purchases.
Types of Credit
While not the only types, two of the main types of credit are installment credit and revolving credit. Both installment and revolving credit come with interest rates, potential fees, and repayment terms.
Installment Credit
Installment credit is a type of credit where you receive a lump sum upfront that you then pay back in fixed amounts over time, usually with interest. Examples of installment credit include personal loans, car loans, and mortgages.
Revolving Credit
Revolving credit allows you to borrow as much or as little money as you need up to your credit limit. Once you repay your balance, you can borrow that amount again. While you have to at least make a minimum payment each month, you can carry over your balance onto the next month.
Types of revolving credit include credit cards and home equity lines of credit (HELOC).
Tips for Building Your Credit
When working to build credit from scratch, here are some tips to keep in mind.
Make On-Time Payments
Since payment history makes up 35% of your credit score, you’ll want to prioritize staying on top of your payments. Ideally, you’d pay off your full balance each month, but make sure you’re at least making the minimum payment to avoid a late fee and negative effects on your credit.
Keep Your Balances Low
Keeping your balances low will make them more manageable to pay off. Plus, it will help you to maintain a lower credit utilization, which is a comparison of your credit card balances against the total credit limit across all of your cards. Credit utilization makes up 30% of your credit score, and a lower credit utilization ratio is generally viewed as more favorable.
Don’t Apply for More Credit Than Necessary
When you apply for a credit card, it results in a hard pull of your credit, which will usually negatively impact your score. Further, too many credit applications in a short window of time can raise a red flag for lenders, as you may appear overextended. In turn, you’ll want to apply to cards sparingly, and only those you’re most interested in.
Keep an Eye on Your Credit
Monitoring your credit will help you learn how different financial movements and behaviors affect your credit score. It also will alert you when your score takes a dip, and when it increases. Plus, it can help you detect suspicious activity.
How Credit Scores Work
Credit scores are calculated using dozens of different scoring models. However, the most widely used scoring models for consumer scores are FICO and VantageScore.
These scoring models take into account various data that appears in your credit report. This information is compiled by the three major credit bureaus — Experian, Equifax, and TransUnion — and sourced from various creditors who report your borrowing and payment activity.
That information is then distilled into a three-digit number that’s known as your credit score. Interestingly, while everyone’s credit score is based on five main categories of information, how those categories are weighted can vary from person to person. For instance, if you’re just starting to establish credit, your length of credit history will be weighted differently than it would be for someone with a lengthy credit history.
Factors That Affect Your Credit Score
As mentioned, there are five main factors that are considered when determining your credit score. These are:
• Payment history: Your history of making payments on-time is considered the most important factor in your credit score by FICO. Even just one missed payment can negatively impact your score. Given the importance of a good credit score, it’s wise to avoid falling behind.
• Amounts owed: Otherwise known as credit usage, this looks at how much of your total available revolving credit you’re using. It’s recommended to keep this rate at no more than 30% to avoid negative effects, so keep this in mind when using a credit card throughout the month.
• Length of credit history: How long you’ve had your accounts open is another factor that makes up your credit score. As such, think twice before closing old accounts, even if you’re not using them that often.
• Credit mix: A diverse mix of credit — credit cards, auto or personal loans, mortgage — can help your score. Lenders want to see how well you can manage a wide range of credit products.
• New credit: This is the number of new credit accounts you’ve applied for and recently opened. Remember, an application leads to a hard inquiry, which will temporarily lower your credit score. Numerous applications at once can signal increased risk to lenders.
How to Check Your Credit Score
You can check your credit score in a few different ways:
• By signing up for a free credit monitoring service
• Through a credit card issuer, lender, or money management app
• With a nonprofit credit counselor
With any of the above options, just make sure to note the terms before requesting your score — there’s no need to pay for information you can get for free.
Calculating Your Credit Score
Credit scores generally range from 300 to 850, though someone’s starting credit score isn’t necessarily at the lowest end (nor will it be zero). While exact intervals can vary a bit depending on the scoring model, here’s a look at how FICO breaks down the credit score ranges:
• Poor: 300 to 579
• Fair: 580 to 669
• Good: 670 to 739
• Very good: 740 to 799
• Exceptional: 800 to 850
As mentioned, five factors are taken into account when calculating your credit score: payment history, amounts owed, length of credit history, credit mix, and new credit.
When it comes to how exactly your score is calculated, it gets a bit complex. Consumer scoring models, such as FICO and VantageScore, use statistical analysis methods to find patterns of behavior that are linked to your perceived ability to pay back your loans.
The Takeaway
Credit is important in your life as a consumer. It can help you make purchases you wouldn’t be able to, opening doors to new financial opportunities. Further, having a strong credit can save you in interest and fees, and make it more likely that you’ll get approved for more competitive credit opportunities.
If you’re in the search for a new credit card, consider a rewards credit card to make your money work for you. With the SoFi Credit Card, you can earn cash-back rewards on all eligible purchases. You can then apply those rewards toward your balance as a statement credit, redeem points for stock in a SoFi Active Invest account, and more.
FAQ
What is a simple definition of credit?
Credit is the agreement under which someone borrows money to access goods and services, with the expectation that they’ll then pay back the amount borrowed in full, along with any applicable interest charges or fees.
What is the difference between credit and debit?
With debit, the money spent is deducted from existing funds you have in an account. Credit, on the other hand, allows you to borrow money that you’ll repay at a later date.
How do I get to know my credit score?
You can check your credit score in a number of ways, including a free credit scoring website, through your credit card issuer or lender, or by visiting a nonprofit credit counselor.
Photo credit: iStock/tommaso79
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