Imagine this: you’re me and you’re at lunch with one of your best friends. She’s complaining that she doesn’t have money for something she really wants and she’s worried it’s going to sell out before she gets paid at the end of the month. You reply, “Why don’t you just put it on a credit card and pay it off when you get your paycheck?”. She tells you she doesn’t have a credit card (*gasp*), in fact she doesn’t know how they work or what credit even is (*even larger gasp*).
Credit can be really confusing, but I’m going to try and break it down for you.
So what the heck is it? Credit is basically your word. It’s how companies or banks know if they can trust that if they give you money or services, you will pay them back. Your credit is attached to your social security number, so it will follow you your entire life.
But wait, what is a credit score? Your credit score is a number between 300 and 850. It’s like a grade for your credit. The closer to 850, the better your word. This number is how the lender decides whether or not to give you the money or services you want and at what interest rate (more on this in a minute).
Now, there are several kinds of credit lines: revolving credit, service credit and installment credit. Technically, there’s also charge cards, but those are rare, so we’re going to ignore those. Revolving credit is your credit cards. You have a limit of how much you can spend at a time and you have to make minimum payments to pay that back every month. Service credit is your bills. You use services all month (ie. water, power, internet, etc.) and at the end of the month you have to pay it back. Installment credit is loans. You ask the bank for an amount of money to make a large purchase (ie. a house, car, college, etc.), and you pay it back slowly over time.
Ok, got it, but what is interest? When you borrow money (installment credit AKA loans), you get charged interest. This means that you’re paying back a percentage of that money on top of the money you borrowed. For example, and let’s keep it simple, you want $100. You get it, but at a 5% annual interest rate. A year goes by and you don’t pay any of the $100 back, you now owe $105. That’s interest.
So how do you get good credit? You have to build it.
Your credit is affected by how many lines of credit you have, how old your longest credit line is, how many times you’ve asked for a new credit line (inquiries), how much you owe, and how many missed payments you have. Generally speaking, you want a couple lines of credit, you want to have it for as long as possible, you don’t want to ask for a new line very often (wait at least six months in between loans or new cards), you don’t want to owe too much (you only want to owe a small percentage of your credit limit at a time), and you don’t want to miss any payments. You build credit over time, you won’t get an amazing score overnight.
But why do you need good credit? Well, unless you can pay in cash, you’re going to need loans for your first house, a new car, graduate school, etc. The bank will decide whether or not to give you these loans and how much interest they’re going to charge you based on your credit. Many credit card companies have perks too. Some give you 1% cash back, others may give you travel points.
But what happens if you miss a payment? Missing a payment is not the end of the world. You’ll probably get charged a fee and your credit score will go down a little bit. But be careful, because the more payments you miss, the bigger the consequences will be.
Credit is how you get things you need or want now, but can’t afford. Good credit will make your life easier and bad credit will make your life harder. So if you haven’t started building credit yet, I’d suggest you start. You can thank me later.