What is Credit? And how does it work?

The reality of being an adult means you can no longer see the world behind rose-colored glasses – I mean you can, but you’ll be greeted with a slap in the face. I’ve always had a love-hate relationship with looking at the behind the scenes stuff. You know – learning about how things really work.

When I was younger, I naively thought: people grow up, make big grown-up decisions, and everything magically falls into place.

Well, they say ignorance is bliss for a reason because there’s so much more that factors in when you make these big decisions as an adult. Learning about credit and how it works wasn’t necessarily magic-shattering but it did open my eyes to a whole new world.

I'll always cherish the originalmisconception I had of you

So what is credit?

Whether you’re borrowing money from a bank or a friend (do not recommend unless you can Venmo them in a timely fashion), you are expected to pay it back — actually, banks REQUIRE you to pay it back – friends just expect it.  If you don’t pay the money back on time, you’ll either lose a friend or worse yet, get charged interest. You’re given that credit (trust) – now whether it becomes good or bad, that’s up to you.

My mother always cautioned me to not purchase anything with a credit card unless I could pay it off completely by the end of the month. I still follow her advice to this day. Unless there’s some sort of emergency, I don’t recommend you purchase anything you cannot pay off by the credit card bill date.

Why credit is important

Building credit is important for when you want to make next-level purchases such as a house or a dog (yes, I really want a dog if you haven’t realized by now). In order to make these purchases, you might need a loan and banks need to know they can trust you first. They do this by looking at your credit report. This report contains all your information – think: SSN, DOB, credit and payment history, income, current and former addresses, jobs, civil lawsuits (not scary AT ALL). All this is peculiarly analyzed to predict future behaviors – will you pay on time or are you bound to mess up? I still have yet to learn how this really works as it’s a bit ambiguous (what gives, FICO?). Anyway, your credit report generates a three-digit number that becomes your credit score that ranges from 300 to 850 (the higher the score, the better). The number then has the power to determine your creditworthiness.

Your credit score can determine future interest rates, loan eligibility, and can even influence potential employers and insurance companies. No pressure.

Don't tell me how to spend my money (1)Like Yin and Yang – there’s good credit and there’s bad credit. Factors that can negatively affect your credit are late payments, bankruptcies, foreclosures and opening up to many credit lines at once. This information can stay on your credit report for up to 7 years. The good news is that your credit can always be improved.

Here are some tips to build “good” credit:

  • Pay off your credit card every month
  • If you feel comfortable – set up autopay. Almost every company has this option now – thanks internet.
  • Don’t purchase something you know you cannot pay off at the end of the month to avoid being charged interest
  • Keep track of your purchases (Excel is your friend)
  • Don’t close your old accounts – the amount of time credit card accounts are opened (and paid off) can impact your credit score; usually, if you have a history of these two things it can positively impact your credit score.
  • Even if you’re given a high credit limit on your credit card, don’t go chasing waterfalls – keep your balances low

Total household debt is at an all-time high at 13 trillion dollars. This includes mortgages, student loans (I despise you, Sally Mae), consumer debt…definitely enough to yell “I DECLARE BANKRUPTCY!” You don’t want to add to that debt if you can help it. I took out student loans that I’m still paying off (side note: WHY is school so damn expensive?!), however, as far as credit cards go – I try to contain myself.

PSA to all you wanderlusters – I’ll be talking about the best Travel Credit Cards next -you’ll definitely need a decent credit score for those.

Disclaimer: I didn’t major in finance but I do a ton of research and make educated guesses/conclusions – choose wisely.

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Categories: smart money networkTags: , , , , , , , ,

Sarahi

Sarahi is the founder of Gems & Potatoes. She is passionate about early financial education, travel, and finding ways to live smarter. Sarahi was born and raised in Boise, Idaho so is naturally always planning for the next outdoor adventure.

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