What is Credit and Why is it important?
Credit is essentially a loan of money or resources with the agreement to repay it over time. Proper credit management can lead to lower interest rates, better loan terms, and increased purchasing power. Conversely, mismanaging credit can result in high interest rates, significant debt, and a damaged credit score. This article will help you with understanding credit and utilizing it the right way for effective budgeting planning.
Types of Credit
1. Revolving Credit: This includes credit cards and lines of credit. A credit limit is extended to you and you can borrow till the limit. If you repay or make minimum payments you continue your usage. Interest rates on revolving balances are generally high and important to manage wisely.
2. Installment Credit: This type involves a fixed amount borrowed and repaid at a fixed period. Examples include personal loans, auto loans, and mortgages.
3. Open Credit: A pre-approved loan between a borrower and a lender. The borrower can make repeat withdrawals and repay it based on an agreed due date. This credit often converts to either an installment loan or a credit card.
4. Charge Cards: These work like credit cards. So, what is the difference between a Credit card and a Charge card? The payback requirement. Charge cards require you to pay off the entire borrowed amount each month.
Understand how Credit Scores work and the right way to use credit
1. Understand how credit scores work: What is a credit score? It is a reflection of your creditworthiness. Credit scores range from 300 to 850. A higher credit score can lead to better terms of loan and lower interest rates. Three major Credit bureaus (Equifax, Experian, and TransUnion) keep track of credit scores and it is advisable to check them regularly to ensure accuracy.
2. The right way to use credit: Make payments on time (A big contributor to a score), keep balances low (typically do not exceed 30% of your available credit limit), diversify your credit (revolving credit, installment credit, etc.), and monitor your credit score for errors or fraudulent activity.
3. What is a credit score scale factor: We look at two scales and their factors for calculating credit scores. (FICO™ Score and VantageScore)
The standard chart for the FICO score is as below:
A. Payment History (35%)
B. Amounts Owed (30%)
C. Length of Credit History (15%)
D. New Credit (10%)
E. Credit Mix (10%)
VantageScore’s scale factors are a bit different:
A. Payment History (40%)
B. Depth of Credit (21%)
C. Utilization (20%)
D. Balances (11%)
E. Recent Credit (5%)
F. Available Credit (3%)
TakeAway
Each individual has a credit journey. However, people can navigate budgeting better if they understand credit and personal finances better. How to achieve a better credit score? Understanding credit, making your payments on time, utilizing diversified credit, and maintaining the correct balance leads to better financial health. Self-assessed surveys (US Households) conducted by federal reserves show that low income, Black households, and Hispanic households struggle to access the right credit. That said, now you may be better equipped, to navigate your credit and make sound financial decisions. Also, having a good credit score may not guarantee a mortgage or a loan. Each lender has different criteria for loan approval and may also take income into consideration. What is a good credit score? We will post a new article soon.
