Credit is an important financial concept that each and every individual in an economy must be aware of and understand. Whether you want to buy goods with a credit card, or want to be able to take mortgage loans from the bank so that you can buy a house, you must have a good understanding of what credit is, and ensure you keep your credit healthy. In this lesson, I will cover the definition of credit, where it is used, and why you must keep a good credit score.
What is credit?
In school, you may have heard of credit with regard to an assignment. A teacher may tell you “if you do not put your name on your paper, you will not receive credit for this assignment.” The teacher is willing to give you that credit, but is trusting you to do that assignment first. The teacher has to have a belief in you before you receive the credit.
The financial definition of credit is a little more nuanced and has a different conceptual meaning than the one you may hear in school, but the idea that trust and faith between two parties remains constant. When we refer to credit in the financial sense, we are talking about a certain level of trust or belief that one party will be able to repay a debt or a loan granted to them. This may sound complicated, but I will guide you through it.
You probably know about credit cards, how they work, and when they are used. Credit cards are now the widely used method of payment for any consumer good, ranging from grocery store items, to gas, to retail purchases such as clothes. You may commonly see commercials for different credit cards, offering different benefits for using their card, such as cashback on purchases and loyalty rewards.
Credit cards rely on credit, as we have defined above, in order to be used and issued. Suppose that you want to get a credit card in order to buy goods. You will have to apply for the credit card through one of these companies. In order to be considered for the credit card, you will definitely need to have a good credit score.
Credit Score and How to Build It
Credit score refers to a number that a person is assigned based on how trustworthy they are regarding their payments on debts and loans. The credit score is calculated to reflect how well one can be trusted to be responsible for their payments. Credit scores are incredibly important for financial well-being and security. A FICO credit score is within the range of 300-850, but a good credit score is defined as being between 670-850. Based on statistics from Experian, only 66% of Americans have a good credit score or better.
It is very crucial to maintain a good credit score. This can be done by ensuring a few things. Firstly, you must make sure to keep your spending under control. If you spend too much money, have to take out loans, and then can’t repay your debts, your credit score is going to be lowered permanently. Secondly, you must pay your bills on time and in an orderly fashion. Even if you have the money to settle all of your debt obligations, you must pay them in the first place. Forgetting to repay a debt can also permanently affect your credit score.
Why is credit important?
Once lowered, your credit score can put you at risk for financial downfall. Assuming you don’t have much extra cash for unexpected costs, you are at a great risk. What if your car breaks down? You can’t take out a loan, because your credit score is too low and banks don’t trust you to loan you money. As a result, you can’t drive to work. What if you are hit with unexpected medical costs that your insurance doesn’t cover? You are stuck in a hole. In order to truly maintain financial freedom, a healthy credit score should be one of your first financial priorities.
In today’s economy, especially in America, consumers save only 18% of GDP. America is a consumer society. In other countries, savings rates are as high as 40%. It is especially important to live below your means, so that your credit score and freedom will be preserved. Don’t get caught up in purchasing the new iPhone, or a new sweatshirt that you so desperately want but know you can’t afford. Although these concepts may not affect you now, it is good to start building healthy financial habits that carry on into the future.