What is credit?

David Berger is an Associate Professor of Finance with Oregon State’s College of Business, who spoke with Beaver’s Digest on how credit can be an asset being practical with credit spending. This interview has been edited for clarity.

Q: What is credit?

A: I think the general idea is that credit, and kind of the financial system in general, allow you to separate when you consume – which could be medium consumption, but also includes housing and a car and things like that – from when you actually earn the money. 

The typical life cycle is, a lot of times when you’re a student, you’re not making a lot of money. Later in your job, as you’re growing your career, you make more and more money, and then you maybe think about retiring, you are drawing back your savings for these things when you spend credit. 

For a lot of the folks that might read Beaver’s Digest, credit might be a way to basically borrow against future earnings. It’s about bringing some of the extra earnings that you are going to make later back to today. 

Q: What do I need credit for?

A: A lot of the big ones (purchases). Potentially buying a house, buying a car, those sorts of things where you don’t necessarily have the money now. I couldn’t necessarily walk into the car dealership and drop tens of thousands of dollars in cash to have the car today, but with credit, I can finance that purchase. So I can have access to that transportation sooner rather than later.

Q: How about credit score? What do I need a credit score for?

A: Something that younger folks should know is your credit score can save you a lot of money. 

There are tons of criticisms about it. But basically, the higher the credit score, the lower the interest rate that you’re going to pay. So, if you’re financing a house, financing a car – consumer debt – you’re going to pay less interest if you have a higher credit score. If you are going to take on consumer debt, the savings from having a higher credit score are really, really, large. 

Q: How do I find out if I have good credit? And does checking your credit score affect it?

A: My understanding is that the soft checks, short of specifically pulling credit because you’re going to buy a car today, does not negatively impact your credit score.

Q: What do I need credit for if I am not planning to take on any major purchases?

A: I can’t think of an example off the top of my head where if you don’t have a credit card, if you’re not going to have an auto loan, if you’re not going to have a home loan, any day-to-day situations where you need a credit score.

Q: Do I have to have a credit card if I want to improve my score?

A: It depends. One thing they look at in your credit score is capacity and how much is used. For example, if I had access to $10,000 of short-term consumer debt, and I was borrowing $9,000, that’s riskier than if I only had $1,000. 

One thing I know that can hurt people is closing lines. Let’s say you had a credit card, and you close that credit card line, now your capacity goes down and that can hurt your credit score.

I think that you can build credit without necessarily taking out a credit card. There are different credit scores and different kinds of credit rating agencies, and they each use slightly different formulas, but I do think that access to credit is included in the credit score. 

Q: So, how long should I keep a credit card open for?

A: My wife and I talk about it like this: If we have ice cream at home, we’re going to eat it. Borrowing too much can definitely hurt you financially. So, if you’re someone that is going to borrow and spend because you have access to it, then closing a credit card can be a really good idea. Sort of the equivalent of not buying ice cream at the grocery store. 

If you’re not one of those people, someone who can have access to credit and know you’re not going to splurge or make impulse purchases, and it’s just there for somewhat of a rainy-day fund, there’s no reason to close that credit card as long as you’re not carrying a balance. 

Q: Should I ever have more than one credit card? 

A: You certainly can. I have a couple. 

Basically, the short version is that credit card companies make most of their money on people who carry a balance. So, if I spent $100 on my credit card this month, and if I pay it off this month, I’m not paying them any interest. But if I spend $100, and I keep some of that balance going forward, that’s going to accrue interest. Over time, the people that leave that balance open, those are the ones that are really, really profitable for the credit card company. 

A lot of credit card companies offer incentives to get people to use their credit card. If you’re responsible with paying off that balance, some of those perks are kind of nice. I’m not going to advocate for one card or another, but we have some different credit cards that offer some bonuses in terms of managing monthly expenses. And you know, then paying off the balance at the end of the month. 

There’s also something nice about a credit card, and that if I go out somewhere and pay with my credit card, I’m not linking back to my checking account. I like that separation.

Q: If I wanted to improve my credit score, how could I go about doing that?

A: The biggest thing is paying on time. Avoid delinquencies, don’t miss payments, just pay everything off as it comes along.

Q: What about if you’re in a hole?

A: It’s tough. The way I like to think about it is, credit is not necessarily a bad thing. Personally, I get paid over nine months, so I am not making a ton of money in the summer. If I borrow a little bit in the summer against what I am going to earn in the coming academic year, that’s a nice way to spread out the consumption that I wouldn’t have without credit. 

But, the exact amount you can borrow and pay back is a little uncertain. For example, maybe I will borrow a little bit this month because I am expecting some overtime, but my overtime hours end up getting cut. The thing to keep in mind is that if you overestimate your ability to pay back, and you’re not able to meet those obligations, that is when things get bad. Penalties for late payments and interest rates go up, and there are a lot of ways that when you get in that delinquent area, you are penalized even further. 

I definitely think credit should come with a lot of caution, in terms of making sure that you can pay it back because once you get into a hole, it gets tougher and tougher to dig out, with interest rates piling up.

Q: When should someone start building credit? 

A: I think for a long time that the conventional wisdom was when you’re 18, when you’re starting college. I think now it’s about the benefit of building a lengthy credit history and showing agencies that you can handle a balance and pay off monthly expenses. 

On the other hand, I push that against the sort-of personal responsibility that we talked about earlier. When do you feel comfortable having that kind of responsibility? It is easy to make an impulse purchase if you have access to $1,000 in credit at any time you want, versus if you have to actually pay with cash. The benefit is building your credit history. Maybe you aren’t ready for that yet. Maybe you are.