In the complex world of personal finance, credit plays a pivotal role that can shape the course of our financial destinies. From securing a mortgage to obtaining a credit card, the concept of credit weaves through numerous aspects of our financial lives. Yet, for many, the inner workings of credit remain shrouded in mystery. Fear not, for this blog post is here to unravel the intricacies of the credit conundrum, providing you with a comprehensive understanding of how credit works and why it holds such significance.
The Basics of Credit:
At its core, credit is a financial arrangement that allows individuals and businesses to borrow money with the promise of repayment in the future. This borrowing is facilitated by financial institutions, such as banks and credit unions, which extend credit in the form of loans, credit cards, or other financial instruments.
The Credit Score:
Central to the world of credit is the elusive credit score, a numerical representation of an individual’s creditworthiness. Ranging from 300 to 850 in the widely used FICO score system, a higher score indicates a more favorable credit history. But what factors contribute to this all-important number?
- While there are many components that impact a credit score there are two main ones. The first is how timely you make your payments. Meaning, how many late payments, collections, charge offs, etc. that you have on your credit. This makes up 35% of your credit score. The second main component of credit scores is the balance on your revolving accounts such as credit cards in relation to your available limit. For example, if you have a credit card with an available limit of $1,000 and you owe $900 on that card you have a 90% usage ratio. Generally, the lower the usage ratio the better your credit scores are.
- One key to credit is that you can directly affect that usage ratio by making sure you keep your usage ratio low. Meaning, rather than have one credit card with a high balance relative to its limit, you can spread that balance out over several cards and lower your usage ratio.
- Credit Inquiries are another factor when it comes to your credit score. Maintaining a low amount of credit inquiries is crucial. The more credit inquiries you have the bigger the impact it will have on your score.
- Credit History and long-standing credit cards will also impact your score. The age of a credit card that is in good standing can help your scores. A credit card that has some years on it is much better than a brand-new credit card when it comes to your scores, which is why you do not always want to close out those credit cards that have good history.
The Impact of Credit on Financial Opportunities:
Why does credit matter beyond the realm of borrowing money? Your credit score can significantly impact your ability to secure favorable interest rates on loans, rent an apartment, or even land that dream job.
In a world where financial decisions are becoming increasingly complex, understanding how credit works is an invaluable skill.
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