Some people just prefer to pay for everything with cash, so they don’t think having credit is important.
But what do you do when you want to purchase something large, like a car or a house? Chances are, you’re going to need a loan. And for a loan, you’ll need credit.
You have to determine for yourself if building credit, which is mostly done through credit cards and loans, is a good move for you. Having a credit score will likely be helpful for you in the future, if you don’t have one already. So what exactly is credit? Here are four ways it can help you and how you can go about building credit.
What Exactly is Credit?
Building good credit helps you to get low interest rates on house and car loans and might even help you to land lower insurance rates.
Before learning how having credit might be beneficial, it’s important to understand what credit is.
The New American Oxford Dictionary defines credit as “the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.” In short, credit is financial trustworthiness.
If you want to buy a car or house but do not have the cash to pay for it in full, then you have to take out a loan.
Your credit score determines if you are a safe investment for a creditor — a creditor makes its profit from the interest on the loan. A bad credit score, or no credit score at all, tells the creditor that the applicant is a risky investment and is not likely then to grant you the loan. A creditor loses money when the borrower doesn’t pay back the loan. (Financial institutions don’t stay in business long if they make a habit of lending money to people who don’t pay them back.)
There are four types of credit:
- Revolving Credit: These are your credit cards, whereby you have a line a credit, carry a monthly balance and make a minimum payment on that balance.
- Charge Cards: These are similar to credit cards, but you must pay your balance in full each month.
- Service Credit: These are your monthly bills — electricity, water, internet and other services — whereby a provider allows you to pay monthly for the goods provided to you in advance.
- Installment Credit: This is your typical car or home loan. A creditor loans you a certain amount of money and you agree to a payment schedule to pay back the creditor every month a part of the principle along with interest.
How Can Credit Help Me?
So, now the question remains — “Why do I need credit?”
To Get Home, Car and Personal Loans
In 2012, about 32 percent of home purchases in California were cash transactions and the numbers across the country are similar. And, then there’s the rest of us who are unable to pay for a house with cash and must take out a loan to buy a home.
Having a credit score helps you to take out the loan. No credit, no loan.
One of the initial steps to obtain a VA home loan is to get preapproved. Veterans United requires a minimum credit score of 620 for loan pre-approval. And, the better your score, the more likely you’ll get approved for the desired amount and the lower the interest rate will be. The same holds for other types of loans and lending institutions.
Not only is your credit score a major factor for obtaining a loan, it also determines what sort of interest rate you can get.
Let’s look at how your credit score affects home loan interest rates: Let’s say you’d like to buy a home in Texas for $100,000 with a 30-year fixed-rate mortgage. With a credit score of 620, according to myFICO.com, your APR would be around 5.33 percent, as of June 11, 2013. With a credit score of 700, the rate drops to about 3.95 percent. That’s a savings of about $30,000 in interest payments over the life of the loan.
The lesson: The better your credit score, the less money you’ll have to spend in the long term to buy a home.
To Get Lower Insurance Rates
Not only does your credit score affect loan interest rates, but it can also influence car and home insurance rates.
Many insurance companies use your credit score to determine what sort of rate to offer you. The idea is, the better your credit rating — you pay your debts and bills faithfully — the more responsible you are and the more likely you are to be a safe driver and safe homeowner. Thus, the lower your insurance rate is.
In 2007, the Federal Trade Commission reported to Congress that credit-based insurance scores are “predictive of the claims made under automobile policies.” That means, there seems to be a relationship between one’s credit history and how likely one is to make a car insurance claim.
To Bolster Your Chances of Employment
Having bad credit, or even no credit, might prevent you from getting that desired job. About 47 percent of employers check a potential hire’s credit report as part of their background investigation.
Keep in mind, your credit report is different from your credit score, which creditors see. It is a line-by-line summary of your credit history, including credit accounts, credit inquiries and public record information such as bankruptcies, liens and judgments. Having a clean credit report, so the thinking goes, suggests to the employer that you are a responsible person.
To Rent a House or an Apartment
Many landlords and management companies check a potential tenant’s credit. If you lack credit or have poor credit you might be denied a lease. If a rental company does decide to approve you for a lease, you can expect to be required a cosigner or to pay a higher deposit.
How Do I Build Credit?
If you haven’t established credit, there are some simple steps you can take to help establish and build up your score.
1. Piggybacking
The first thing you can do is to get yourself added as a Joint Account Holder or as an Authorized User to someone else’s credit card. Ask a person you trust and who trusts you — parent, sibling, spouse or friend. You will then reap the benefits — or harms — of that person’s history with that card. Therefore, you should choose that person wisely.
2. Get a Starter or Secured Credit Card
You’re next move, and a very good one, is to get a secured credit card of your own. A secured card means that you have to pay a deposit to a bank for it to open a line of credit for you — a $500 deposit gets you a $500 credit limit. After a year or so, you get your deposit back. When you’ve established enough credit, then you’ll be able to get a card without having to put down a deposit. Also, it’s good to keep a line of credit open.
3. Get a Gas Station Credit Card
Another move to make is to get a gas credit card. Most of us always have to buy gas, so why not build credit by paying for it with credit.
4. Pay Your Bills On Time
Regular on-time bill payments — credit cards, utilities, telephone, internet, etc.— gets reported to the credit bureaus. Fidelity in this area helps to strengthen your scores.
Need help establishing or improving your credit? Give our Lighthouse Program experts a call at 888-392-7421.
Photo courtesy of Håkan Dahlström