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What is credit?

What it is, how it works and types of credit to know

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woman holding credit cards
Credit is money
you have access to.
Debt is money you owe.

In its most basic definition, credit is an agreement between an individual (the borrower) and a bank, credit card or other service provider (the creditor). People can get credit from traditional financial institutions or providers such as department or electronics stores that offer their own store card or financing program, though these are usually backed by larger financial institutions. Credit cards are the most common type of credit.

With credit, you’re entitled to spend up to your credit limit without providing immediate funds to cover the cost of the purchase. Unlike a loan, you don’t have to take out your entire credit limit at once — instead, you have access to a specific dollar amount to spend (or charge) as you see fit.

Credit may also refer to the creditworthiness, credit history or credit score of an individual. For example, if you hear someone say they have good credit, it generally means they have a high credit score and a strong history of paying their creditors on time.

How credit works

To get credit, you must first apply. During the application process, the creditor will determine your creditworthiness.

Creditworthiness is typically broken down into five categories, known as the five C’s of credit:

  1. Credit history: Sometimes referred to as character, this is your track record with past credit reflected on your credit report. Essentially this is asking: Do you pay your bills on time? Can you be trusted with the amount of credit you’re asking for?
  2. Capacity: This is where creditors analyze your ability to pay back any accrued debt. They’ll use things like your debt-to-income ratio to determine your capacity.
  3. Collateral: This comes into play for secured loans, like buying a car or home. The physical item you purchase becomes the collateral, which can be seized if you fail to pay as agreed. You may also use assets you already own as collateral for a personal loan.
  4. Capital: For credit purposes, capital is any money paid in advance, like a down payment. These are common for vehicle and home purchases but won’t come into play if you’re simply looking to secure a credit card.
  5. Conditions: This refers to the factors and fine print of your credit or loan, including interest rates and repayment terms.

If approved, you should get quick access to your credit. What you charge on the line of credit becomes debt that must be paid back within the terms and conditions established by the creditor.

Types of credit

There are three major types of credit.

types of credit

Revolving credit

The most common type of revolving credit is a credit card. With revolving credit, you get access to a maximum credit limit, which is the total amount you’re able to borrow. When you use your credit card or line of credit to spend money, you're responsible for a monthly payment to keep the account current.

Most credit cards require a minimum monthly payment and allow any additional balance to transfer month over month, but it’s a good idea to pay off your total balance whenever possible to avoid accruing extra debt from high interest rates. If you make the minimum payment, or any payment less than the total balance, your balance carries over into the next month and accrues interest.

Installment credit

It’s likely you’ll experience installment credit at some point in your life. Car loans, mortgages and student loans are common forms of installment credit. You borrow a specific amount of money and pay it off in equal installments over a set term, which could be months or years, depending on the nature of your loan.

Open credit

Open credit is a less common form of credit. Unlike revolving credit, open credit requires you to pay your balance in full each month. Examples of open credit include a charge card, not to be confused with a credit card, and utility accounts, such as your electric or water bill. The utility company “credits” you with electricity or water each month, and you pay your balance for what you’ve used when the month is over.

Why you need credit

The world we live in often depends on credit to get things done. Building your credit history and having a good credit score can certainly make your life easier in the long run. Having good credit helps you qualify for important purchases, such as a new car or your first home.

Even if a big purchase isn’t in your immediate future, having some credit history comes into play more than you might think. If you’re looking to rent a house or apartment, it’s likely your landlord will run a credit check before approving your application. Similarly, utility companies and even future employers can check your credit to learn more about you.

It’s smart not to rely too much on credit or take on more debt than absolutely necessary, but using a credit card to make affordable purchases you can pay off helps build your credit history and lets you secure credit more easily in the future.

Credit facts vs. fiction

Does checking your credit score lower it?
No. Checking your own credit score is considered a soft inquiry and doesn’t negatively affect your score. These inquiries are only visible to you on your credit report and cannot be seen by potential lenders.
Will your score drop if you apply for new credit?
It can. Your score may be affected by a new credit inquiry, but these effects are usually minor and temporary. However, if you take out a new line of credit, that affects your debt-to-income ratio, which affects your score.
Will a poor credit score stay with you forever?
Not necessarily. There are several ways you can improve your credit score. A low credit score doesn't have to stay low, and it certainly doesn’t determine your future.
Does bankruptcy hurt your credit?
Bankruptcy stays on your credit report for seven to 10 years and can impact your creditworthiness in the eyes of certain creditors and lenders. Bankruptcy is only ever recommended as a last resort.
Will reporting rent to credit bureaus help my credit score?
Rent payments aren’t typically reported to credit bureaus by landlords. However, all three credit reporting bureaus say they will report on rent if they receive the information. The VantageScore and FICO 9 and later consider rent payments when calculating your score. There are free and paid services you can use to get your rent reported to the bureaus so it can be considered.
Is it hard to improve your credit score?
It may take a little time, but improving your credit score isn’t overly complicated or difficult. If you work diligently to pay down existing debt and don’t take out new debt, your score will continue to improve.
Credit report vs. credit score: What’s the difference?
Your credit report and your credit score are different things. Credit reports are offered by three major reporting bureaus: Experian, TransUnion and Equifax. These reports contain your credit history, current credit usage and a record of any late or delinquent accounts. Credit reports don’t generally include your credit score. You can access your credit score by using a credit score service, which many credit report sites offer. You can also buy your FICO credit score from myfico.com. If you have a credit card, many offer free access to your score on a monthly basis.
What is a credit score based on?
Several factors go into determining your credit score, including your debt-to-income ratio and payment history.
How long do negative items stay on your credit report?
About seven years. Negative items may include late payments (30 days or more), delinquent accounts, collections and bankruptcies.
What is good credit?
What’s considered a good credit score can vary somewhat by lender, but typically a score more than 700 is considered good.

How to get credit

Understanding and using credit is often a necessity in the modern world. Sometimes, we need help. If you’re looking for additional resources to guide you through the world of credit personal finances, you should research credit cards to find a cash back credit card or secured credit card that's right for you.

If you find yourself in the need for credit repair, a credit repair company may be able to help you raise your credit score and take advantage of more financial opportunities.

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