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Credit. Credit cards. Credit scores. Interest. Late fees. Anyone else’s blood pressure rising just reading that list? There are a lot of unknowns when it comes to credit and credit cards, and I think that’s one of the reasons why there are so much fear and anxiety around them. People know a little bit about credit – information they’ve picked up here and there, but when it comes to actually understanding it, how it can impact you, and what it can do for you, sometimes it can be hard to grasp. This is especially true when you are trying to piece together the information you read with what you have heard.
This is Part 1 of a two-part series on credit and credit cards. This post is pretty heavy – heck, I needed a couple cups of coffee to get through writing it, but it is also so crucial because it lays out the basics. And understanding these basics will help everyone who feels a little “iffy” on the whole credit card scene move right on down to “confident”. Part 1 will be all about cutting through the murky unknowns of all things credit and Part 2 will play Mythbusters and focus on debunking some of those misconceptions out there.
Spoiler Alert: I am going to be talking about credit cards a lot on here because they are a big part of the reason Sarah and I are able to travel so much. Without the sign-up bonuses earned from credit cards, we would never be able to accumulate enough miles to redeem for actual get-on-a-plane-for-free travel. (I always get a lot of questions about this, ranging from “When will you go to jail?” to “How do I get in on this?” – head here for more details).
I think it is very important to take ownership of credit and what it is and how it impacts you because there are a lot of great ways credit can work for you. When I first dove into credit cards, there was a lot of myths and misinformation I had to sort through in order to feel fully comfortable and in control of my own credit destiny. Sarah’s probably laughing at just how cheesy the phrase credit destiny sounds, but she knows it’s true! With something as important as credit, it is crucial to stay organized and on top of your game – and I think the best way to get that foundation is to first understand what credit is. So, without further ado, let’s get going!
What is Credit?
First, what exactly is credit? Investopedia defines credit as “a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some date in the future, generally with interest”. So breaking that down and looking at it through the lens of the most common form of credit, a credit card is issued by a bank and allows the user to purchase items on credit. So for example, I want a brand new, 4k 80 inch TV to watch Tom Brady on, but I don’t get paid until next Friday. I can use my credit card (aka the bank’s money) to purchase the TV as long as it is less expensive than my credit limit (the amount the bank trusts me with, essentially). Eventually, a payment will come due on the credit card, and I will have to pay it, and any interest, off.
So wait, how does the bank know if I am trustworthy or not? Well, there are 3 major credit bureaus, Experian, Equifax and TransUnion. Each of those companies compiles data on people, with help from the banks I have credit with, to create what is called a “credit report” for individuals. Inside of this credit report is important information that the bank tells the credit bureau about me, like the date I opened my credit card, those three times I missed my payments, and what my payment history looks like, to name a few things.
Think of credit reports like a summary of your dating history… but for money. Every time you apply for a new line of credit, whether that is a credit card, a mortgage or something else, the lender (most of the time a bank) will go to one of the credit bureaus and ask for your credit report, so it can make sure you’re a good person to trust with their money. So keeping the dating example, the lender is like your significant other’s mom stalking your Facebook making sure you are a good fit for their beloved child.
But what about these “credit scores” I keep hearing about? Where and when do they come into play? Credit scores were designed to measure risk – the lower the score, the riskier the individual – and FICO or VantageScore are other companies that take the credit report data from one of the 3 credit bureaus, analyze it, and produce a “score”. The credit score is often what we gravitate towards over credit report because it is easy for lenders to measure risk depending on where a person lands on the scale that goes from 300 – 850. So, what goes into this score?
Here’s how it works:
– 35% relates to payment history
– 30% relates to amounts owed
– 15% relates to age of credit history
– 10% relates to new credit
– 10% relates to different types of credit used
This “mix” of different factors all contribute to your credit score and each of them plays a different, but important role in assigning a number on the scale to your credit history in particular. The higher the score, the better, and that basically means banks are more willing to trust you with their money and allow you to have a credit account with them. It also means lower interest fees and larger credit limits – to name a few benefits – but the important takeaway is that having a good credit score is incredibly important.
The Simple Summary
Hopefully this brief overview of credit, credit reports and credit score all was helpful in clarifying what makes up “credit”. Because credit and everything related to it is so essential and also so confusing, some people just avoid credit and credit cards altogether. This is generally a mistake because having good credit is an important gateway to larger purchases like homes and cars.
Credit is important, but once you have the basics down, it can also be very easy. I want to make sure I am clear about that, so I decided to write a whole post on how to treat your credit card and this post on how to raise your credit score. Check them out – I promise you it will help you get more comfortable with credit.