Learning about the financial system in the U.S. can be intimidating at first. How does credit work? What is a FICO® score? What type of loan(s) should I get? Can I even get a credit card? How do I start building credit?
Here is an in-depth breakdown of how credit works, and how you can build and take advantage of the benefits of having strong credit.
What is credit?
According to Experian, credit is the ability to borrow money or access goods and services with the understanding that you will pay later.
Simply put, it’s a show of good faith to allow you to buy things you can’t afford at the moment, or defer payment for something you want over a longer period of time so you can get the things you want or need right away without a huge, immediate impact on your finances.
Why is credit important?
Your credit history shows people how trustworthy you are repaying your debts. Having a strong credit history means you can be offered higher credit limits and/or lower interest rates on loans.
So why do you need credit? Couldn’t you just go through life without ever building credit?
Yes, you technically can go through life in the U.S. without ever opening a credit product as long as you have enough money to pay for everything with cash.
One of the main benefits of having credit is a credit score. Credit is usually required for buying a car, as well as renting an apartment or buying a home, and can even be viewed by some employers during the hiring process.
Different types of credit
There are two main types of credit: Revolving credit and Installment credit.
Installment credit products are loans for a set amount that you borrow from a lender to pay for something that you agree to pay back over time.
Some examples of installment loans are auto loans used to pay for a car over time, and personal loans if you need funds for a different type of purchase like furniture or to pay for a wedding. The only catch is that in exchange for the ability to pay for large purchases up front, you will have to pay some interest, or extra money, on top of whatever you borrow.
Revolving credit lines are loans that never close. They are a set amount of credit that a lender provides so you can buy things as you need them and repay, usually in monthly installments with interest.
Now that you understand what credit is and why it’s important, let’s go through building your credit.
FICO® scores and how to build your credit
Building credit is as simple as using credit; get a loan, use it, and pay it back on time. The easiest way to start building credit is to apply for a credit card and use it for regular purchases, such as gas and groceries. The more you use it, and the more you pay it back, the better your credit score.
The FICO® score (more commonly known as a credit score) is a ranking from 300 to 850 that indicates how much of a risk factor you are when it comes to paying back your debts. Generally, the higher your score, the more likely lenders are to grant you credit and charge you lower interest rates.
Your credit score is affected by a number of things, but it’s mainly determined by these five (5) factors:
So how are you supposed to know if you have a good credit score? Does it hurt to check your credit score regularly? Not necessarily because there are two types of credit checks: hard and soft inquiries.
According to Experian, a soft inquiry is when you or someone you allow (like an employer) checks your credit report. This doesn’t affect your score because it isn’t tied to a credit application.
A hard inquiry, which is an inquiry tied to an actual credit application will affect your score since it is an inquiry for a real loan. There is a temporary decrease in your score, and in the case of looking for a home or auto loan, multiple inquiries of the same type within a certain period (14-30 days) are counted as a single inquiry.
You are also entitled by law to a free hard inquiry annually for yourself through annualcreditreport.com, and Stanford FCU provides your free FICO® Score quarterly in Online Banking and in the mobile app! Score quarterly in Online Banking and in the mobile app!