What is Credit and Why Do I Need It?

The term “credit” can be defined as money, goods, or services given with the expectation of future repayment. Typically, credit is offered under specific terms in the form of a contract. Those terms include the amount of credit (the loan) when it is initially offered and/or disbursed, the full amount to be repaid (initial offering plus interest) and the frequency and timing of the repayment. Credit can be as big as a mortgage or as small as contracting with a neighbor to mow your lawn weekly and promising repayment at the end of the month.

If you want or need something now but don’t have enough cash to cover the cost, you need credit. If you want or need something now but prefer to build savings or to leverage your money for another investment, you need credit. Credit isn't inherently good or bad, but it is something you should learn to master.

Start Small

If you establish good credit early in your financial journey, lending institutions are likely to view you as a favorable risk. This means you’re more likely to be offered loans at higher amounts and with the lowest interest rates available.

There are many ways to start building good credit. You could open a basic credit card account with a small spending limit, then make a purchase or two each month. Start with a small amount that you will repay in full each billing cycle. If you do this for at least twelve months, then banks and other lending institutions are more likely to approve you for a loan in the future. The most important takeaway here is to pay off your credit card in full each month.

A second method for building credit is to establish a good payment history with your landlord. When you apply for your first mortgage, the underwriter will request a rental history. In the absence of a long credit history, your rental history will weigh heavily on the underwriter’s risk assessment.

Avoid Rookie Mistakes

1. Avoid credit blunders that happen early in adult life (such as bankruptcy or auto repossession). These will show up on your credit report long after the end of the legal proceedings. Of course, mistakes like these could happen during any phase of life, but they are especially damaging to one’s credit profile when good credit has not yet been established.

2. Start on the right foot and don’t overcommit. According to investment guru Dave Ramsey, “We buy things we can’t afford with money we don’t have to impress people we don’t like.” This unfortunate but common adage doesn’t have to apply to you.

3. Resist the temptation to overextend your finances. Delaying gratification now will pay off big in the future. It's recommended to use under 30% of the credit on your card. Maxing out your cards is bad news!

Credit Score Tip

Keep your oldest account (assuming it’s in good standing). If you have an old credit card or open-ended loan on your credit report, consider keeping it open and making a small purchase once or twice a year. Then, pay off the full balance within 30 days of each purchase. All other factors held constant, the credit repositories (Equifax, Experian, and TransUnion) give higher scores to longer credit histories versus shorter ones. To see all five factors involved in determining your credit score, take a look at this article. 

The Cosigner Controversy

A cosigner is simply a joint signer on a loan, promissory note, or another debt instrument. Cosigning can make a loan package more attractive from an underwriting perspective because it often leads to a lower risk assessment. A typical example would be when a parent cosigns on an auto loan for their teenage child. This can help the younger party build credit if the parent has established credit and is willing to become a party to the loan. The downside to cosigning is that the established party, who may or may not have any legal interest in the collateral (the car, house, or whatever is being purchased), is still on the hook if the primary signer fails to repay. Discuss roles and expectations in detail before entering into any cosigning relationship.

A stable society where goods and services are traded every moment relies on credit. It keeps the markets moving. Start small, avoid mistakes, and build a solid credit profile early. Making good choices and delaying gratification now will help tremendously if you want to build a solid financial future.