What is credit and how is it used?
Living without credit is difficult. Today’s world requires good credit, but what is credit – and what makes it good or bad? To keep your credit healthy, you need to know how it works, how to keep track of it, and how you can manage it.
What is credit?
Credit is about lending: your ability to lend and the amount you have lent. When it comes to loans (such as credit cards, car loans and home loans), your credit is your reputation as a borrower.
It tells lenders how likely you are to repay your loans, which helps them decide whether to approve your loan application and how much to charge.
Your credit consists of information about your lending history. Most of the information comes from your credit reports.
What is a Credit Report?
Credit reports are a collection of information, including:
- Loans you have used in the past, even if you paid them (usually the last seven years, though there are exceptions)
- Credits you currently use (including unused lines of credit)
- How much you have borrowed
- Minimum monthly payments requested
- Your Payment History – Did you make a late payment or always on time?
- Public records such as bankruptcy and foreclosure
- Any credit you have settled and is in collections
Your credit report is the main document behind your “credit”. Based on that information, lenders decide whether or not to offer you a loan.
However, most lenders do not look at your credit report. Instead, a computer program goes through the information and creates a credit score (see below). A high score means you are more likely to get a loan approval at attractive rates.
When someone wants to see your credit report or get a credit score, they request it from the credit bureau (also known as a credit reporting agency).
Under federal law, you are also allowed to view your credit reports at least once a year. See how to request reports.
What are the credit bureaus?
Credit reporting agencies collect all the information that appears in your credit report. These are informative repositories, but they may not store as much data as you think. For example, your annual income is not part of your basic credit reports.
Again, they get that information from the lenders you worked with, databases from public records and other sources. They distribute or sell that information when you apply for a loan, or when someone requests a credit report (such as an employer or landlord – who needs your permission before the report can be published).
There are numerous credit bureaus, but the “big three” have the biggest influence on what is commonly referred to as your “credit.” It is essential that the information in each credit bureau is correct – if there are errors in your credit reports, they must be fixed or you will be denied credit (and this can cause problems in other areas such as job applications or auto insurance rates) .
What is credit score?
Credit bureaus have a ton of information.
There are hundreds or thousands of lines of information about you in their databases, and it’s hard for lenders to sort through all that. Not enough hours are available for a bank, credit union or online lender to read each credit applicant’s credit reports manually.
As a result, most lenders use credit ratings instead of reading credit reports.
Loans are numbers generated by a computer program that is read through your credit reports. In its history it looks for patterns, features and red flags. Based on what the program finds, it extracts a credit score. Ratings are easy to interpret for lenders – they can only set rules based on the level of your score. For example, credit scores above 720 may be automatically approved, loans between 650 and 720 receive higher interest rates, and other loans are not approved.
While federal law provides free credit reports, it does not provide free credit scores. However, you can buy credit scores from credit bureaus, and there are several ways you can see your credit scores for free. Keep in mind that there are numerous bonuses out there to learn how they work and which are most important.
What is credit used for?
Credit was originally used for lending decisions, but credit scores and reports in other areas of your life appear. Consumers and legislators are constantly looking at what credit they are used for, and discussing the fairness of credit scoring and increasing the use of those results.
Lending money: This is the most common use of credit scores. Potential lenders want to know if you are likely to repay your loans on time. Since they do not know you personally, they try to make a prediction based on previous loan experience. Offered credit without a credit check is generally expensive.
Insurance Coverage: Insurers check their credit to determine whether or not they will cover you, and at what rates. They use insurance results that are slightly different from standard points.
Recruitment: Some employers check their credit even though you have to give them permission to do so. I guess they are trying to gauge how responsible you are for your financial history. In some jobs, the link makes sense (they want to avoid situations where you might be tempted to bribe), while in other jobs the link is less clear.
Utility charges: You may need to get a credit check to get services such as electricity or water. If this is not possible (because you have not yet built a loan) or you have bad credit, service providers often require a larger deposit.
Rental: Similar to utilities, your next landlord may ask you to withdraw your loan. Depending on the rental market, your loan may prevent you from renting or leading to a higher deposit.
There is a lot of confusion about credit information. The most important information used in a credit decision is the information from your credit reports and the details you include in the application. For example, your income is not included in your credit report or score, but lenders need to know whether or not you can afford repayment (by calculating debt-to-income ratios, for example) – so they ask about income on the app.
Read more about factors that work and do not affect your credit.
How is Credit Beneficial to Consumers?
Loans can be useful or harmful to consumers. To see the pros and cons, return to the broader definition of credit: the ability to lend.
Lending allows you to buy expensive things. If you wanted to buy a home, you may have to spend hundreds of thousands of dollars in a savings account, which is not feasible for most people. A mortgage loan allows you to own a home, control your living environment and build equity in the home (if you are lucky, the value of the home will increase).
Car loans provide a safe and reliable means of transportation. Student loans allow for a high level of education, which often leads to higher living wages and a better standard of living.
With credit, consumers can pay for expensive things with small payments. Unfortunately, temptation (and sometimes just bad luck) can cause problems. When you borrow, you have to repay. If you cannot afford the payments for any reason, your credit will suffer and you will face high costs (delays, legal costs and so on). Attractive “0% interest” offers can end up surprisingly expensive.
Even if you always pay on time, credit can be a parasite in your finances. For example, payday loans are extremely expensive loans that often last for months or years. Paying only the minimum amount on your credit card results in a long-term relationship with your debt. It almost always costs money to borrow, and some people choose to live without debt and credit to avoid costs and risks.
What about credit scores? These are probably helpful for consumers as a whole, but they are a problem if you have bad credit.
Credit points make it cheaper to borrow because lenders can more or less automate lending decisions. Moreover, lenders do not discriminate on the basis of race or other characteristics of borrowers (credit scores should eliminate any discrimination), so lending is more fair.
Finally, lenders can reduce their losses by avoiding borrowers who are more likely to default, which keeps costs down for other borrowers. The downside, of course, is that if you have bad credit, you will have a hard time getting credit. Fortunately, it is possible to build a loan and rebuild it after falling into difficult times – and improvements can come in a few years.