What is the deal with credit?

What’s the difference between a credit report and a credit score? What is FICO? Are credit cards a necessary evil? Excellent questions. Here’s my short(ish) explanation.


If you don’t have time to read the whole post, be sure to scroll down and check out the tips at the end!


Back in the day, banks would loan money to businesses and individuals based on their reputation or existing relationships. A banker would say “Oh yeah, I know Bill. He’s got a job over at Henry’s. He’s very trustworthy and reliable and we can count on him to pay us back if we extend a loan.” Or a banker might say, “Frank. What a disaster. The poor guy can’t even keep a job for more than a few days. It’s definitely too risky to lend him any money.” I mean, I wasn’t there, but conversations like this probably happened. Anyone applying for a loan would also have to put something up as collateral, meaning if they used their house for collateral and didn’t pay back the loan, the bank would own part or all of their house. The banks needed to know that they would have some way to get the money back in the event that it wasn’t repaid directly.

Obviously this is not the case today. Now, instead of depending on a person’s references or a personal relationship, lenders can also look at their credit report to determine whether or not to extend credit. A credit report is the compilation of every financial move you’ve made in your lifetime. It is based on your social security number and includes a full history of all your credit cards and payments (including retail cards – like that Target card you’re always pressured to open to save 15%); any school, auto, or home loans; current balances; and your current and past addresses. This collection of information is designed to show how likely you are to pay your rent, utility bills, credit card or loan balances. And in case you’re wondering where all this info comes from — the companies who lend you money are the ones who provide this information to credit bureaus.

Instead of reading through all of your accounts and balances and address changes and every other little detail, lenders can look at your FICO score (the most common credit score) to make a faster decision about loaning money to you. (Fun fact: the name FICO comes from the creators of the score at Fair, Isaac, and Company.) FICO scores are based on a formula: a record of paying your bills on time – or not (35%), the total balance on your credit cards and other loans compared to your total credit limit (30%), your length of credit history (15%), any new accounts and recent applications for credit (10%), and your mix of credit cards and loans (10%).

how-credit-works

Ok, so credit reports are a way for businesses to determine if you will pay them. Whether you’re trying to get a credit card because you’re broke or just want perks, or you’re applying for a car or home loan, trying to rent an apartment, or even just setting up a new utilities account — they all want to know that you’re good for the money.* So lenders will look at your credit score to find out if you have a history of paying back your debts. This can lead to a catch-22 type situation. Like when you try to get a job but you’re supposed to have experience but you can’t get experience without a job. Same thing here. You can’t get credit (or a decent loan) without previous credit or loans. That’s where credit cards will often come into the picture. There are plenty of credit card companies who are willing to “take the risk” on people without this credit history. Why would they do such a thing? They make big bucks on interest. Anytime you don’t pay off your monthly balance, you’re also charged an additional percentage of the total owed.

So if you have to use credit to have credit in order to get credit (ex:  use a credit card to have credit history to get a car or home loan), why does Dave Ramsey, for example, suggest that credit cards are the devil? Ultimately, he says, they cause you to spend more. For one thing, the perks can encourage unnecessary spending. For example, if you get cash back, you might feel like you’re “earning” money when you’re really still spending money – just not quite as much as you would without that card. His example was 3% cash back – if you buy something for $100, you get $3 cash back. But did you earn the $3 or did you just pay $97 instead of $100? If you really need the $100 item you purchased, that’s one thing. But if you were persuaded to buy it because of the $3 back, that was a real win for the credit card company (because they get a % of each transaction – meaning the store doesn’t get the full $100 either). So Dave is saying you’re incentivized to spend money. Good point. His other point is that you’re also not discouraged from spending money. In other words, if you use cash, you can physically see your money going away. You don’t like seeing money go away, so you’re less likely to spend it without thinking. Another good point.

But is life without a credit card realistic? Maybe. You can still make purchases online (if you must) with a debit card. So it’s not like you can’t operate in the world without one. And older, financially established people who already have a car or house can, and probably should, stop using credit cards. They are less likely to need to apply for a loan but if they do, they have a history of paying for that car or house. But most young people don’t have any other form of credit. You can probably still get a car or home loan (if you need one) without a credit history (and therefore a low credit score), but your interest rate will likely be higher which means you will pay more over time. What’s a responsible young person to do?

I absolutely am not any kind of professional financial adviser, but I think it can be reasonable to get a credit card and use it like a debit card. In other words, use it on purchases here and there (or for all of them if you’re suuuuuper responsible), but pay off the balance on a regular basis. Like, daily if necessary, to keep yourself from spending money you don’t have. And that’s the key: DON’T SPEND MONEY YOU DON’T HAVE. I know that is confusing in this whole discussion of credit cards and loans. But when it comes to credit cards, don’t use them unless you have the money to pay off the balance right away.** And for car or home loans, you need to know that you will be able to make the monthly payments no matter what – because you have a solid income and because you have some money saved in case of an emergency (like a job loss).

Credit Card Tips:

  • Always always always always always pay your monthly statement balance on time. Always.
  • If you absolutely can’t pay the full balance – a) we have a bigger problem to address about spending money you don’t have but b) pay the minimum due to at least avoid the late fees. You’ll still have to pay interest but at least you won’t have an additional penalty.
  • Choose one with the lowest interest possible.
  • Don’t get one at every store where you do your shopping – stick to one. You don’t need to keep track of more than that. Besides, every time you apply for a card, it is reflected on your credit score. And no, not in a good way.
  • Regularly check on your account – keep track of what you’re spending and make sure there are no fraudulent charges.
  • Keep your balance low. Your credit score goes down if you’re using a high percentage of your credit limit. For example, it doesn’t look good if your credit limit is $5,000 and your balance is more than about $1,500.
  • Use something like Credit Karma to monitor your credit and make sure it isn’t compromised by fraud as well as to get tips for improving your credit score.

Additional Resources:

Nerd Wallet’s Credit Card 101 and Money Under 30’s How Credit Works and How to Build Credit the Right Way. And, as I’ve mentioned before, I think Suze Orman’s Money Book for the Young, Fabulous, and Broke is a great resource for learning the basics of financial stuff before it’s too late. Credit Karma will show you your credit score and help you understand how to improve it, if necessary.

And lastly, I highly recommend this episode of Bad with Money: Transactors and Revolvers (aka Credit Cards) for more credit 101 as well as a great explanation of how and why this system is broken and biased.***

 


*But apparently not student loans? You can get masssssive student loans for college without any history of repayment. I guess they know students are unlikely to have a credit history, plus that’s the kind of debt you can’t get out of unless you actually DIE.

**I’m not saying I’ve never spent money I didn’t have. But more on that later…

***That’s a whole other post.

 

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