What Is Credit and Why Does It Matter?

Credit can be best defined as an exchange. It’s when something of value is exchanged in return for the promise of a payment, usually with interest attached.

Credit simply refers to a situation where something of value such as cash, a home or a vehicle is given in exchange for a promise of payment. When most people think about the term credit, however, they think of a credit rating and whether they have good credit or bad credit.

While credit is a fairly simple concept, in theory, it can be a difficult concept in practice. Credit is a guiding force of our financial lives. It shapes our purchase decisions and our ability to buy homes. It impacts our ability to get auto loans and can even help us qualify for employment.

Unless you have extremely large amounts of cash at your disposal, credit is necessary. Here we’ll cover the types of credit, why it’s important and your credit score.

Why Do You Need Credit?

In today’s credit-driven society, credit is necessary because people rarely have the immediate cash available to make large purchases such as a new home.

While we might fantasize about arriving at a luxury car dealership or a real estate closing with a suitcase full of cash, this isn’t a reality for most people. We pay for a lot of things we need or want with credit. We are then tied to the terms and conditions of paying that money back — whether that be the specific timeframe, the amount of interest or other conditions.

What Affects Your Credit Score?

If you pulled your credit report for the first time and were shocked by a low score, you may ask yourself, “what went wrong?” Understanding the factors that make up a credit score will help you uncover where you can take immediate action to improve it in the future.

There’s a lot of information that funnels into this three-digit number and it’s not a one-size-fits-all approach. Credit ratings vary by your unique circumstances. The score itself is derived from an algorithm that helps lenders predict financial risk. Let’s break down what goes into a credit score and how you can better understand each factor.

The five main factors that affect your credit score are:

1. Payment History: 35%
2. Credit Utilization: 30%
3. Length of Credit History: 15%
4. Different Types of Credit: 10%
5. New Credit: 10%