What is Credit and How Does Credit Work?

Summary:

Credit is your ability to borrow money, usually based on how responsibly you’ve used debt in the past. It can also refer to a loan agreement between a lender and a borrower.

If you’ve ever attempted to make a major purchase, then you probably understand just how important credit is. It can help you pay for big-ticket items, like houses or cars. But it can also help you out of a tight spot in case of a financial emergency.

When you start working to improve your finances, you’ll see the term “credit” thrown around a lot. It actually has a couple of different meanings in the world of personal finance. And in this article, we’ll explain what credit is, how credit works, and how to improve your credit.

What is credit?

The term “credit” in the personal finance context has two different meanings. First, credit can refer to your ability to borrow money.

When you have good credit, it means you’ve shown that you’re a responsible borrower. As a result, lenders will be more likely to give you money for something like a mortgage or auto loan, a credit card, and more.

On the other hand, having bad credit means you’ve handled debt and other financial obligations irresponsibly in the past. As a result, lenders may be less likely to offer you loans or may charge you a higher interest rate to do so.

Credit can also refer to an arrangement between a borrower and a lender. Think of a credit card. The card issuer is giving you credit, which allows you to borrow money using your credit card. You pay interest on the debt and must pay the money back, usually on a set schedule.

The two definitions of credit are interlinked. Your creditworthiness is the most important factor that impacts your access to credit, meaning loans and lines of credit from lenders.

How does credit work?

Your credit is your ability to borrow money. And when we talk about creditworthiness, we’re usually talking about two key factors: your credit report and your credit score.

Credit reports

Your credit report is a summary of your credit activity. It’s compiled by three major credit bureaus: Experian, Equifax, and TransUnion.

Your credit report shows all of your open credit accounts as well as past accounts, including credit cards, mortgages, auto loans, personal loans, and more. For each account, your credit report will show the date the account was opened, your credit limit, and your current balance. It also shows your history of payments on each of your credit accounts, including whether you’ve had any late or missed payments.

Pro Tip

Because there are three credit bureaus, you also have three credit reports. The contents of each credit report should be the same, so make sure you get a copy from each. You can get a free copy of your credit report using AnnualCreditReport.com.

Credit scores

Your credit report is important, but it’s not the only thing lenders care about. The other important factor in your credit is your credit score. This is a three-digit number that signals to lenders whether you’ve used debt responsibly in the past.

Credit scores fall on a scale from 300 to 850, with a higher score being better. Within this scale are five different ranges: excellent, very good, good, fair, and poor.

Those with excellent and good credit won’t have much trouble borrowing money. Meanwhile, those with poor or fair credit will probably find that loans and credit card accounts aren’t as readily available to them.

Pie chart showing the different elements that make up a credit score calculation
How FICO calculates credit scores

Credit scores are made up of five key factors. Those factors, along with the percentage of your credit score they account for, are:

  • Payment history: 35%
  • Credit utilization: 30%
  • Length of credit history: 15%
  • Credit mix: 10%
  • New credit: 10%

Pro Tip

There are multiple credit scores, with the most common being the FICO score and the VantageScore. Most lenders use the FICO score when determining loan eligibility.

Types of credit

As we mentioned, credit can refer to an agreement between a lender and a borrower where the lender agrees to give the borrower money as long as they agree to pay it back (usually with interest). There are three key types of credit:

1. Revolving credit

Revolving credit refers to a debt that you can continually borrow money and repay it up to your borrowing limit. An example of a revolving credit is a credit card.

With a credit card, your lender gives you access to a certain amount of credit. For example, someone might have a credit limit of $1,000. You can borrow money as often as you want as long as your balance never exceeds $1,000. And as long as you repay what you’ve borrowed, you can continue to borrow money.

In addition to credit cards, other types of revolving credit accounts include personal lines of credit and home equity lines of credit (HELOCs).

2. Installment credit

Installment credit is a type of loan that you borrow in one lump sum and then repay on a set schedule, along with interest.

An example of installment credit is a personal loan. When you take out a personal loan, the lender agrees to give you a certain amount of money. Once you’ve received that lump sum, you can’t get any more money from the lender — at least not without taking out a new loan.

Once you’ve received your loan, you’ll immediately start making monthly payments based on a set schedule. The amount of time you’ll have to repay the loan depends on the type of loan it is. A personal loan might need to be repaid in a year, while mortgages are often repaid over 30 years.

Other examples of installment credit (or installment loans) include auto loans, student loans, and home equity loans.

3. Service credit

Service credit refers to an agreement you have with a service provider. For instance, you have service credit with your utility company. Each month, you use the electricity the company provides. And at the end of the month, you’re expected to pay for what you’ve used.

Other examples of service credit include your phone bill, internet plan, gym membership, and more.

Pro Tip

Unlike other types of credit, service credit doesn’t usually show up on your credit report if you pay your bill on time. However, it may be reported if you miss a payment, which will cause a drop in your credit score.

The importance of good credit

If you’ve ever applied for a credit card or tried to borrow money, then you probably already know how important credit is.

First, your creditworthiness impacts your ability to borrow money. If you have a bad credit history, lenders won’t trust you with borrowed funds, and you aren’t likely to be approved for any loans. And any financing you do receive probably won’t have the best

Additionally, your credit history impacts the interest rate at which you can borrow money. Even if you’re approved for a loan, having fair or poor credit could result in you getting a higher interest rate. On the other hand, someone with excellent credit can likely borrow money at the lowest interest rates.

Your credit can also impact areas of your life you may not expect. Here are just a few examples:

  • Signing up for insurance. Insurance companies often use credit as a factor when setting rates. A low credit score could result in you paying higher premiums. And if your credit is bad enough, you could be denied insurance altogether.
  • Renting an apartment. Landlords often run credit checks when you apply for an apartment. Like lenders, your landlord wants to know you’ll be able to pay your bill on time each month.
  • Getting a job. Employers sometimes run credit checks on prospective employees. Depending on the type of job you’re applying for, poor credit could prevent you from being hired.

How to build credit

Building credit can be a difficult process, especially if you have missed payments and other negative marks on your credit score. The good news is there are plenty of steps you can take to boost your credit score, even if you’re starting low.

  • Make on-time payments. It might be the most tedious strategy to boost your credit score, but it’s also the most effective over the long run. Your payment history is the most important factor in determining your credit score, so a long history of on-time payments will go a long way in helping you keep your score up.
  • Become an authorized user. Becoming an authorized user on someone else’s credit card is one of the best ways to boost your credit score quickly since you get credit for the payment history on the account. Just make sure that, if you do this, the person who adds you as an authorized user uses their credit cards responsibly.
  • Pay off debt. Your credit utilization — meaning the percentage of your available credit you’re using — makes up 30% of your credit score. Lenders generally like to see a utilization of 30% or lower. If yours is higher than that, consider paying off some debt.
  • Increase your credit limits. Just like paying off debt can improve your credit utilization, so can increasing your credit limits. Credit card companies often increase the credit limit for long-time borrowers with good payment histories.
  • Get a secured credit card. A secured credit card requires a deposit that acts as your credit limit. Because there’s less risk for the lender, they grant these cards to borrowers with poor credit who may not otherwise qualify for a credit card. A secured card can help you boost your credit score, and eventually, you can upgrade to a non-secured card.

Pro Tip

Checking your credit reports regularly can help you learn what might be keeping your credit score low. It can also help you identify errors that might harm your credit score. If you find these errors, you can dispute them with the three credit bureaus.

On the other hand, if you don’t have the time to do it yourself, you can hire a credit repair company as well. Though this service comes with a fee, a credit repair company can scan your credit report for errors and report any incorrect information to the credit bureaus on your behalf.

FAQs

What is a credit score?

Credit scores are three-digit numbers that show lenders how responsibly you use debt and credit. The higher your credit score, the more creditworthy you are.

How is credit counted?

Your credit score is counted using your payment history, your credit utilization, the length of your credit history, your credit mix, and any new credit inquiries.

What is a good credit score?

Generally speaking, a good credit score is one that’s 670 or higher. However, the credit score you need to borrow money or qualify for a credit card depends on your lender and other factors on your credit report.

How do I build credit for the first time?

You can build credit by making on-time payments, paying off debt, increasing your credit limits, becoming an authorized user, and more.

Key Takeaways

  • Credit usually refers to someone’s ability to borrow money based on whether they’ve met their financial obligations in the past.
  • Your personal credit is made up of your credit report — which is a summary of your financial obligations — and your credit score — which is a three-digit number that reflects your creditworthiness.
  • Credit can also refer to an agreement between a borrower and a lender. Examples include revolving credit, installment credit, and service credit.
  • Your creditworthiness can determine whether you can borrow money, the interest rate at which you can borrow it, and even whether you can get insurance, rent an apartment, or get a job.
  • Generally speaking, your credit score will increase as your payment history and credit utilization improve since these are the most important factors that make it up.

Watch your credit score soar

If you’re working on boosting your credit score, it’s important to have a credit monitoring service in place. These services can summarize the contents of your credit report, show you your credit score, and alert you when there are changes that could affect your credit score.

But finding the right service for you can take a bit of time. To help, we’ve rounded up a list of the best credit monitoring services to help you find the best one for you.

View Article Sources
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  5. How to Build Credit at 18 — SuperMoney
  6. What Is Tier 1 Credit (Or Tier 2 or 3 for that matter)? — SuperMoney
  7. Top 10 Factors That Affect Your Credit Score — SuperMoney
  8. How to Improve Your Credit Score — SuperMoney
  9. How Marriage and Credit Scores Are Related — SuperMoney
  10. Is Bad Credit Better Than No Credit? — SuperMoney
  11. How to Raise Your Credit Score by 100 Points — SuperMoney
  12. Paid Vs. Free Credit Reports — SuperMoney
  13. What is Considered a Good Credit Score? 5 Major Factors That Determine Your Score — SuperMoney
  14. The Ultimate Guide to Credit Reports — SuperMoney
  15. Compare Credit Help Companies — SuperMoney