In a NutshellCredit is a tool that can be used for good but may be problematic if you don’t know how to use it effectively. Using credit reliably and earning good credit scores can help you build wealth and allow you to do business with companies — but you can get into trouble if you don’t understand how credit works.
In 4,000 B.C., when Sumerian people began establishing the world’s first cities, credit was extended for what may have been the first time.
Loans were made with interest in the Sumerian city of Uruk and early versions of financial contracts were exchanged. In the centuries since, different methods of making loans have developed but the basic premise remains the same: People want things they can’t pay for all at once and credit makes it possible to obtain them.
As of 2018 A.D., American households collectively owe an estimated $13.29 trillion dollars, while businesses outside the financial sector owe $14.43 trillion. We’re using credit in very different ways than the Sumerians, but borrowing remains a huge part of our present-day economy. This raises key questions: Why is credit important and how can you get access to it when you need it? Let’s find out.
- Why is credit important?
- Why do I need credit?
- Why is good credit important?
- What are the risks of credit?
- Hear from an expert
Why is credit important?
When consumers and businesses can borrow money, economic transactions can take place efficiently and the economy can grow. Credit allows companies access to tools they need to produce the items we buy. A business that couldn’t borrow might be unable to buy the machines and raw goods or pay the employees it needs to make products and profit.
Credit also makes it possible for consumers to purchase things they need. Many items, from cars to houses, are too expensive for most people to pay for all at once. With credit, it’s possible to pay over time while accessing essential products and services when you need them.
Why do I need credit?
Although credit clearly has an important role to play in maintaining a functioning economy, you may still be wondering why you need credit as an individual.
“Loans are a necessary part of life for many,” says Katie Ross, education and development manager for American Consumer Credit Counseling.
Loans can enable wealth-building by allowing people to do things like pay for college, increase earning power, buy a home and benefit from rising property values, or start a business, Ross says.
“Having access to credit can also be helpful in an emergency,” explains Benjamin Jacobs, a certified financial planner at Elwood & Goetz in Athens, Georgia.
If unforeseen expenses arise or you need something you can’t afford, being able to borrow could be a lifesaver, he says.
Accessing credit is important for another reason in today’s society: consumer credit reporting. When you borrow money, creditors often report your behavior to credit-reporting agencies, including Equifax, Experian and TransUnion. Data on your financial behavior — such as whether you make loan payments late or fail to pay — is aggregated to create credit reports and evaluated to generate credit scores. Those reports and scores are used by lenders when they assess how risky it may be to lend to you.
“In order to establish credit history, you need to have credit,” advises Julie Pukas, head of U.S. Bankcard and Merchant Services at TD Bank.
Why is good credit important?
So why do your credit reports and credit scores actually matter?
“A credit score is highly influential in almost all financial transactions,” Pukas says.
Your credit scores affect your ability to get credit in the future.
“If you mismanage your credit and earn a poor credit score, you’ll be less likely to qualify for loans or credit. Or you’ll end up with a loan with a high interest rate and poor terms and conditions,” explains Ross.
But what if you don’t want to ever borrow and you’re committed to paying cash for your house, car and other big purchases? Even in these cases, having good credit matters, because credit scores are used for lots of things in the U.S.
Landlords may check your credit when deciding whether to rent to you. When you try to get a cellphone contract, your credit scores and reports are usually checked.
“Being a responsible credit card owner shows you’re trustworthy,” Pukas says.
Your auto insurer also may take a look at your credit scores when deciding what rates you’ll pay. And your credit can even affect your job prospects.
“Depending on the state you live in, employers can request a modified credit report from the credit bureaus,” Ross says. “It’s possible to be denied because of negative marks on your credit report.”
What are the risks of credit?
If you were wondering why is credit important, now you know. But just because credit helps you build wealth and participate in the economy, doesn’t mean using it is always good. Credit is a tool, and like most tools, it can be misused.
“If not properly managed, poor credit can negatively impact many of your major financial applications,” Pukas says.
Since your credit scores are used to measure your reliability, inconsistent borrowing behavior and low credit scores will likely make people and companies reluctant to do business with you. You may not be able to get a cellphone contract without a large deposit, or a landlord may not rent to you.
Another big risk: borrowing costs money — in fees and interest — and it’s possible to borrow more than you can repay.
“If a consumer doesn’t know how to handle the credit they have available to them, they could end up paying a lot in interest, as well as paying fines or penalties,” Jacobs says. “This could end up spiraling, and I’ve seen consumers who end up having to file bankruptcy because it spirals out of control so much.”
To avoid problems, Ross says, you should limit borrowing and take out loans only if you can easily repay them. She says it’s also important to distinguish between so-called “bad” debt — debt used to buy things just because you want them — and “good” debt, such as a mortgage or student loans that can help build wealth in the long term.
Getting by without credit can be difficult because the U.S. is a credit-based economy. Without the ability to borrow — and without a positive credit history — you may not be able to make big purchases like a home or a college education and benefit from the wealth-building that may result. But credit’s not the answer to all your financial problems; you need to borrow responsibly and use credit wisely to help, not hurt, your financial future.
Hear from an expert
Q: Why is credit history so important?
A: It is important since it provides information to the lender about your financial stability. It reveals the level of risk they (lenders) will have to absorb when they deal with you.