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Demystifying Credit: A Guide for Young Adults

Published 11 March 2024

Credit is a financial tool that can be a tremendous asset or a significant burden, depending on how it’s managed. For young adults, understanding credit is crucial for building a stable financial future. In this guide, we will unravel the mysteries of credit, explaining what it is, how it works, and why it matters.

 

What is Credit?

Credit is borrowed money that you can use to purchase goods and services when you don’t have the cash readily available. When you use credit, you are making a promise to repay the borrowed amount, typically with interest, within a specified period. It’s like a financial arrangement that allows you to buy now and pay later.

 

Types of Credit

There are various types of credit available to consumers:

1. Credit Cards: These are one of the most common forms of credit. With a credit card, you’re given a credit limit, which is the maximum amount you can borrow. You can use the card to make purchases, and you’ll need to repay the borrowed amount by the due date to avoid interest charges.

2. Loans: Loans come in different forms, including personal loans, car loans, and student loans. When you take out a loan, you receive a lump sum of money upfront, which you must repay over time, usually in monthly instalments.

3. Overdrafts: An overdraft facility allows you to withdraw more money from your bank account than you actually have. It’s a short-term borrowing option, typically linked to your current account.

4. Mortgages: A mortgage is a long-term loan used to purchase property. It’s secured against the value of the property, and repayments are made over many years.

 

How Credit Works

When you use credit, you are entering into a financial agreement with a lender. They provide you with funds, and in return, you agree to repay the borrowed amount, usually with interest. Your creditworthiness, which is determined by factors such as your income, employment history, and credit score, influences whether a lender will approve your application for credit and what terms they will offer you.

 

Building Credit

Establishing a good credit history is essential for young adults. It demonstrates to lenders that you are a responsible borrower and can increase your chances of being approved for credit in the future. Here are some tips for building credit:

1. Open a Credit Account: Consider applying for a credit card or a small loan to start building your credit history. Make sure to use credit responsibly by making payments on time and keeping your balances low.

2. Pay Bills Promptly: Your payment history is a significant factor in your credit score. Always pay your bills, including credit card bills, loans, and utility bills, on time to maintain a positive payment history.

3. Keep Balances Low: Try to keep your credit card balances low relative to your credit limits. High credit utilisation can negatively impact your credit score.

4. Monitor Your Credit Report: Regularly check your credit report for errors or fraudulent activity. You can access your credit report for free.

 

Understanding Credit Scores

Your credit score is a numerical representation of your creditworthiness. It’s based on information in your credit report and helps lenders assess the risk of lending to you. Credit scores typically range from 300 to 850, with higher scores indicating lower risk.

Factors that influence your credit score include:

1. Payment History: Your track record of making on-time payments.
2. Credit Utilisation: The amount of credit you’re using relative to your credit limits.
3. Length of Credit History: How long you’ve been using credit.
4. Types of Credit: The different types of credit accounts you have.
5. New Credit: Recent credit inquiries and account openings.

 

Credit Reference Agencies

In the UK, three main credit reference agencies (CRAs) play a key role in shaping your financial profile:

  • Experian,
  • Equifax, and
  • TransUnion.

While each CRA calculates your credit score using a unique system, they all categorise your creditworthiness into similar bands, ranging from ‘Very Poor’ to ‘Excellent.’ This means the specific score you see might differ slightly between CRAs, but the overall assessment of your credit health will be comparable.

Here’s why it’s important to be aware of your score across all three CRAs:

  • Lenders use a mix of CRA reports: When you apply for credit, lenders may consult reports from one or even all three CRAs. By monitoring your score across all three, you can ensure there are no errors or inconsistencies that could negatively impact your application.
  • Get a well-rounded view: Slight variations between CRA scores can happen due to factors like timing of reported information. Checking all three reports gives you a more comprehensive understanding of your credit health.

 

Why Credit Matters

Credit plays a significant role in various aspects of your financial life:

1. Access to Financing: Good credit can make it easier to qualify for loans and credit cards with favourable terms and lower interest rates.

2. Employment Opportunities: Some employers may check credit reports as part of the hiring process, particularly for positions that involve financial responsibilities.

3. Housing: Landlords often review credit reports when considering rental applications. A strong credit history may increase your chances of securing a lease.

4. Insurance Premiums: Insurers may use credit information to determine premiums for auto and home insurance policies.

 

Conclusion

Building a healthy credit score is a crucial step towards financial empowerment, especially for young adults.

  • Start building your credit history: Explore options like secured credit cards or authorised user accounts on established cards.
  • Become a responsible borrower: Pay your bills on time, every time. This is the single most significant factor impacting your credit score.
  • Monitor your credit reports regularly: Look for errors and take steps to correct them promptly.

By taking these proactive steps, you’ll be well on your way to unlocking the benefits of good credit, such as securing loans for major purchases, obtaining better insurance rates, and achieving your long-term financial goals. Remember, a strong credit score is an investment in your financial future – make it a priority!

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