Rooting your phone is the term used to describe the method of getting super user access (i.e. root access) on Android. The name comes from the "root" account on Linux, which is the administrator account. Android runs on top of Linux. Hence the term "rooting" meaning "getting super user access".
However, what you mean by this, and what many people mistakenly mean by this is actually "installing a custom Android operating system".
Android does not allow you to install unofficial versions of the operating system normally, so in order to do this you need to "root" your phone first to give you the power to override this protection.
Custom firmwares, like Cyanogen's ROMs, can provide you with features that you can't get with the standard versions of Android. But, the real question is, do you need it?
The vast majority of stuff that used to the main reasons to install a custom firmware (e.g. tethering, multiple desktops, bluetooth file transfer, etc) can now all be achieved with apps on the Market, without needing to install a custom firmware or root your phone. But, in many cases, Cyanogen's firmware probably does it better than most of the apps.
There are also some serious risks and drawbacks to installing a custom firmware, such as:
- Never receive an official over the air (OTA) update again, including security updates.
- Risk bricking your phone making it completely unresponsive.
- Invalidate your warranty (so if it is bricked, you may not be able to get a replacement for free).
- Have to reset your phone settings again from scratch as you need to wipe your phone completely.
- Run an unapproved firmware that has undergone no official testing, may have serious bugs, and that may have been designed to run on your specific hardware.
- Rely in the developer of the ROM you choose to be aware of, manually hand port, release, and inform you of any security updates.
As best as I have ever seen any reasonable argument for, there are only two genuine reasons that I personally know of to root your phone. There may be more that I'm not bothered about that you may be of course. Anyway, these reasons are:
- To allow you to install apps on the SD card, thus freeing internal memory making your phone faster in general.
- To allow your speaker to be turned up louder than normal so you can hear your phone ringing better.
Moving apps to SD is a really big deal, and probably the most important reason to install a custom OS.
Most Android phones have a shockingly low amount of application space (70MB or so). It quickly runs out. But, there is still an unresolved issue with installing apps on the SD card. While apps are running they're constantly writing to their installation space to save their state or other data. Apps assume that they're installed in internal memory, which is a very special type of flash memory. This writing is sometimes done many times a second for some apps, but at least once every time the app is ran. Even the SD cards can be written to only around 1,000,000 times before they fail. When that happens, your SD card dies and at best you'll notice that your phone is crashing a lot and becoming unreliable, but at worst (and this is usually the case) you lose everything on your SD card and it become inaccessible. If you have 15 apps running that write once a second to your SD card, then it will fail within 6 months. Just search on this forum for people with SD card problems and you'll see how common it is.
So, my question to you is this... what do you need from your phone that you think installing a custom firmware will give you? Do you need a louder speaker? Most people like the Apps to SD thing and speed increase this will give you (assuming you JUST HAVE to have more than 100 apps installed on your phone so you have no memory left), but are you happy to lose everything one day without warning and void the warranty of your phone?
It's also worth mentioning here that while both rooting and installing custom firmwares does technically invalidate the warranty of your phone, people have successfully returned their phones afterwards and got replacements - but it's still a real risk.
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