Many of you know that my husband and I strive toward debt-free living. We avoid taking on new debt and we work hard to pay off our existing debt, which includes student loans, our mortgage, and a small amount we owe on my husband’s car. Though we’ve gleaned a lot of information about credit throughout our adult years, in examining our finances and planning for the future we’ve learned some finer details that help us navigate the world of personal finance more effectively.
What exactly is credit?
Credit is confidence in a person’s ability and intention to repay borrowed money. A person’s credit with banks, businesses, and individuals can be used to obtain loans. The loans can then be used to buy goods or services. In general, the more credit a person has, the more he or she is allowed to borrow.
The amount of confidence a lender has in a potential borrower depends on a number of factors, including his or her income, current debt, and past handling of debt repayment. This confidence is often expressed as a credit score.
Credit score basics
A credit score is a number derived from a statistical analysis of the information in a person’s credit files (this information is contained in a credit report). Lenders use credit scores to help determine the creditworthiness of an individual. Each of the three credit reporting agencies in the U.S. (Experian®, Equifax® and TransUnion®) has its own formula for calculating credit scores. (This means you may have a different score from each agency.) In general, the higher the score, the better. Even if your scores vary between the agencies, they likely represent the same level of creditworthiness.
Reasons to have credit
Credit is necessary to qualify to take out a loan with which to make a significant purchase (such as a house or car). It is also necessary for obtaining credit cards.
It’s really no surprise that these scenarios require credit, but is it really necessary if you plan to live debt free? If you do not use credit cards and make all your purchases outright, can you get by without it?
While the technical answer to this question may be “yes,” there are a number of benefits to having credit, especially if you have good credit.
- Avoiding security deposits on utilities. If you have good credit, utility companies will often waive the security deposits associated with establishing accounts. Some wireless phone service providers will also allow customers with good credit to sign a contract without paying a security deposit.
- Paying lower car insurance premiums. According to car insurance companies, people with bad credit tend to file more claims than people with good credit. Thus, individuals with good credit scores are often charged less for insurance than individuals with bad credit scores.
- Getting easier approval when renting an apartment or house. Landlords are increasingly using credit scores to screen tenants. A bad credit score may decrease your chance of getting into a property.
- Getting a job. Believe it or not, employers can check the credit of individuals who are applying for jobs with their companies. (The employers do have to have permission from the applicants.) Having bad credit may give you the appearance of irresponsibility or instability, subsequently reducing your chance of getting a job.
- Paying travel-related expenses. Hotels, airlines, and rental car companies prefer transactions be made with credit cards (credit, of course, is a prerequisite for having a credit card). If a credit card can’t be used, then a debit cards is often a suitable alternative. Willingness to take other forms of payment (e.g., cash, money order, personal check) varies from one company to the next. Regardless of the company, using a form of payment other than a debit or credit card is generally a hassle. Paying without a credit card may also cost you more—discounts are sometimes offered when reservations are made early, but a credit card number is almost always required to make reservations.
Next week we’ll look at the difference between a credit score and a credit report and review how credit reports can be obtained for free. In the meanwhile, if you’re looking for more information you can visit my sources: Experian and the Federal Trade Commission.
Do you feel you have sufficient knowledge of concepts related to personal finance? Were you surprised by any of the reasons to have credit?