The Pursuit: Credit

Credit Management

Now that we understand how to start budgeting and saving to meet our short and long-term goals, it’s time to look at another tool in the toolbox: credit. Credit can be daunting, but if used correctly, it’s an effective way to continue reaching long-term financial stability.

What is Credit?

Credit is the ability to borrow money or services with the understanding that you will pay later. In short, it’s debt. Understanding credit can help you build more wealth than otherwise possible, but its misuse can lead to quite the opposite. Let’s start by understanding the types of credit.

Types of Credit

It’s important to note that borrowing on credit will nearly always involve paying interest. Interest is a compound fee that lenders place on borrowers to ensure profit. In other words, each year (or whatever timeframe is specified in the deal) the total amount you owe will increase by a certain percent. This means that the tradeoff for buying things now is that it can be more expensive in the long run, especially if you wait to pay it off for too long. Don’t worry though, this interest can be significantly reduced by building a stronger credit score.

Understanding Credit Scores

A credit score is the numerical representation of your trustworthiness with loans. In other words, your credit score is an easy way for providers to tell how likely you are to repay your loans fully and on time. Scores can range from 300 to 850, with higher scores indicating more creditworthiness.

What Affects Credit Scores?

1. Payment History (35%): The biggest factor affecting your score is the record of how timely you were with your past payments.
2. Amounts Owed (30%): The second biggest factor is the current amount of debt you owe and how much of your available credit you’ve used.
3. Credit History Length (15%): A smaller, but still sizable, impact on your credit score is simply how long you’ve had credit accounts. Providers are more likely to trust someone who is experienced with the credit system than someone who is relatively inexperienced.
4. Credit Mix (10%): This looks at how many different types of credit accounts you have. If you have a variety of accounts, it gives you more opportunities to demonstrate your ability to pay back on time.
5. New Credit (10%): The number of new credit inquiries you have can also impact your score.

How to Build and Maintain Good Credit

1. Repay Bills on Time: This is the biggest thing to keep in mind when considering your credit score. Late credit payments can significantly damage your credit score. Consider setting up reminders to ensure you repay all bills on time.
2. Maintain Low Balances: When possible, try to use less than a third of your total available credit at one time. Having high balances will also negatively impact your score.
3. Keep Old Accounts Open: These old accounts demonstrate financial history and can be beneficial to your credit score.
4. Limit New Credit Inquiries: Large amounts of new inquiries in a short period can also negatively affect your credit score. Try to apply for credit only when necessary.
5. Monitor Credit Report: No system is perfect, so it can be beneficial to regularly check your credit report to protect against errors and discrepancies that might be negatively impacting your score. You are entitled to a free report from each of the three major credit bureaus annually.

Managing Credit

By raising and maintaining your credit score, you’ve likely gotten yourself lower interest rates and more favorable conditions on your loans. That’s great, so here’s a couple more tips to keep your credit under control.

Conclusion

Credit is an important aspect of your financial life. Regardless of whether or not you need it now to buy smaller items, you will likely need it later to buy larger items. That’s why starting a line of credit early to build a strong credit score is important. By paying off your credit in a timely manner on small necessities, you can build the credit necessary to take out larger loans later on reasonable terms. Credit doesn’t need to be complicated. As long as you keep a time schedule for repaying credit and don’t overspend, it can be a very large piece of the puzzle that is your financial health and success.