Building and maintaining good credit is a cornerstone of any sensible personal finance strategy. Keeping up a good credit score opens up all kinds of doors, while a poor credit score severely limits the opportunities available to you. That’s why it’s essential to understand what credit is and how maintaining good credit can work to your advantage. In this article, we’ll explain what credit means, the different types of credit, and go over some of the reasons why it’s important for you to build and maintain good credit.
What is Credit?
Credit can mean a few different things. However, it’s broadly defined as an arrangement between a lender and a borrower, where the borrower receives something of value in the short-term and agrees to repay the lender at a later date. This arrangement typically has an interest rate attached to it as well, meaning that in addition to repaying the loan, you also pay the lender a percentage of the amount you borrowed in order to make the arrangement worth it for them, and to compensate them for the financial risk they’ve taken in lending out money.
Credit can also refer to one’s credit history. Your credit history is a record of the debts you’ve incurred over time and whether or not you’ve been able to pay the amounts back on time and in full. Your credit score is determined by your credit history, and maintaining a good credit score can provide you with more flexible options when making financial decisions in the future.
Having a good credit score can make it easier to secure loans with better terms and lower interest rates, rent an apartment, or buy a car—it can even make getting a job easier, since some employers run credit checks on applicants. That’s all because good credit demonstrates trustworthiness to lenders, and they’ll be more likely to lend you money if they’re confident that they’ll get it back.
We’ll go further in depth about why credit is important later, but first let’s take a look at the different types of credit available and how they work.
The Types of Credit
There are two major types of credit: revolving credit and installment credit. Here we’ll take a look at the differences between the two, and the advantages and disadvantages that accompany each of them.
A revolving credit account is a type of credit where, once the debt is paid off, it will automatically renew the agreed-upon credit limit. The benefit of this type of credit is that it allows you the flexibility to repeatedly borrow money up to a certain limit—otherwise known as a credit limit—and pay it back over time. One example of a revolving credit account would be credit cards, which have a credit limit and interest rate set by the lender.
The reason why it’s called revolving credit is because you have the option to either pay off the debt you incur at the end of each billing cycle or pay a minimum amount and have the rest of the debt roll over (or revolve) into the next billing cycle. Keep in mind, though, that you’ll be charged interest on the balance that carries over into the next cycle, so it’s always a good idea to pay off the debt in full if you can afford it.
When you take out an installment loan, it means that you’re borrowing a sum of money and agreeing to pay it back in fixed installments, with an established interest rate, over a set period of time. Things like mortgages, auto loans, and personal loans are all examples of installment loans.
In contrast to revolving credit, your account is closed once you pay off installment credit and a new line of credit isn’t automatically renewed. Installment credit also tends to be a bit more inflexible than revolving credit, since you’re not permitted to pay a minimum amount each month and let the remaining amount roll over to the next billing cycle—instead, you have to pay the amount in full every time or risk being subject to penalties, late fees, and major hits to your credit score.
Why is Credit Important?
There are a variety of reasons why it’s extremely important to maintain a good credit score. In general, when you borrow money from a lender and then fulfill your obligation to pay it back according to the terms of the loan, you build trustworthiness and increase the chances that other people will be willing to lend you money in the future. But here are some more specific ways that maintaining a good credit score can help you out:
Favorable loan terms
When you take out big loans, whether you’re trying to buy a house, finance a car, or pay for school, lenders are more likely to give you more favorable terms and lower interest rates if you have a good credit score. Even a slightly better interest rate on a loan can save you a lot of money in the long run, especially if you’re taking out something like a mortgage, where the interest alone can add up to tens of thousands of dollars over decades.
Access to better credit cards
The kinds of credit cards that you’re eligible for depend largely on your credit score. With a poor credit score, you’ll likely have few options and may end up having to get a credit card with high interest rates. However, with a good credit score, you can qualify for credit cards that come with low interest rates, unique benefits, and rewards like cash back, travel points, and more.
Better chances of landing a job
Some employers run a credit check before making a hiring decision, especially if the position you’re applying for is related to managing a company’s finances. That’s because companies want to see that you know how to be financially responsible, handle your money wisely, and pay back the debts you owe. Thus, a poor credit score could potentially cause you to lose out on a great job.
Easier to rent an apartment
With a higher credit score, you’ll have access to a wider variety of apartments when you’re looking to move. Many landlords set a minimum credit score that a potential tenant must have in order to rent to them, since the landlord would prefer to rent property to someone who has a demonstrated history of making payments on time.
Lower insurance premiums
Your credit score usually plays a role in how much insurance companies decide to charge you for things like auto insurance. There are a number of factors that go into calculating an individual’s insurance premiums, but those with a higher credit score are often able to qualify for lower premiums.
Building and maintaining good credit will take time and discipline. You’ll have to be diligent about paying all of your bills on time, and careful to spend only what you can afford. It won’t always be easy—if you’re short on cash, it can seem more convenient to use a credit card to sustain your lifestyle rather than setting up a budget and cutting back. But don’t fall into the same trap that so many Americans do. In the long-term, maintaining a good credit score can help keep financial options available and make your life a lot easier.
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