What Is Credit? How It Works and Why It Matters
Written by
Joseph Hostetler
Edited by
Emily Gadd
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When you get a loan from a bank, credit card issuer or other financial institution, you’re requesting credit. You’re making a promise to the financial institution that you’ll pay back the money it’s lending you.
Upon entering into this relationship, you’ll agree upon details like loan amounts, repayment terms and interest rates. The quality of your credit profile determines all of these things.
That’s what your credit score is for. It’s a report card that gives lenders an idea of your ability to handle credit. It tells them, among other things, how faithful you’ve been with on-time payments and whether you’re using a high percentage of your current available credit.
Types of Credit
Credit takes many different forms. You’ll need to decide which type of loan best fits your needs.
Revolving Credit
Revolving credit is perhaps the most common type of loan, as this includes credit cards, bank-issued personal lines of credit and home equity lines of credit, also known as HELOCs. With these loans, you’ll have borrowing power that reduces as you spend — and replenishes as you pay it back.
For example, if you have a $10,000 credit limit, the bank is allowing you to borrow a maximum of $10,000 at a time. If you use the card for a $3,000 purchase, your available credit drops to $7,000. If you pay off $2,000 of your balance, your available credit jumps up to $9,000.
You can continue using revolving credit as often as you need.
Installment Credit
In contrast with revolving credit, installment credit must be paid back within a specific amount of time. The bank gives you a lump sum and presents you with firm repayment terms.
For example, you may take out a $10,000 personal loan. The bank will deposit $10,000 into your bank and present the following repayment plan:
- You must fully pay off the loan within 48 months.
- You’re subject to a 9% interest rate.
- You’ll pay a minimum of $248.85 per month.
Common installment loans include auto loans, student loans and mortgages.
Open Credit
Open credit is a loan in which you can use a product or service before you pay for it. This includes bills such as utilities, which require full payment each month. As an example, you use electricity all month and then pay your electric company based on the amount you’ve used.
What Is Credit Used For?
For better or worse, credit is used for just about everything these days. Unless you’ve got a safe house filled with steamer trunks of cash, you’re going to be applying for many of life’s inevitabilities, including:
- Buying a home: Mortgage lenders check credit before approving home loans.
- Getting a car loan: Auto loans are based on credit scores and history.
- Applying for credit cards: Higher credit scores lead to better credit card offers.
- Renting an apartment: Landlords may check credit reports before leasing.
Beyond that, credit may affect even your career path. Some employers review credit reports for financial responsibility. Utility companies may require a credit check or deposit.
How Credit Affects Your Financial Life
As intimated above, credit is used for just about everything. From making everyday purchases to settling on a house, credit is a vital component of your financial well-being.
That goes for your credit score, too. Here are some common examples of why you need to care for your credit. Lenders want to know how risky of a prospect you are before they entrust you with money or property.
Interest Rates and Loan Approvals
A good credit score can swing open many doors in life. A bad one can nail them shut.
When you’ve got good credit, it’s possible to qualify for rock-bottom interest rates for things like mortgages, auto loans and personal loans. You can also qualify for travel and rewards credit cards which can deliver hundreds — even thousands — of dollars in value each year.
When you’ve got poor credit, your interest rates may be notably higher. You may not even be approved for many types of loans.
Impact on Employment and Housing
You can’t completely escape the consequences of a bad credit score by renting instead of buying. For example, landlords may reject applicants with poor credit histories. If you’ve defaulted on loans in the past — or if you’re carrying a lot of debt — it may worry them that you won’t pay your monthly rent.
Even potential employers may check your credit report, depending on your field or line of work. If you work in finance, you may not be hired if you’ve got a spotty credit history.
How To Build and Maintain Good Credit
Fortunately, maintaining good credit is not complicated. It’s not the easiest, but the process is straightforward.
Pay Bills on Time
The single most important step you can take to build healthy credit is to always pay your bills on time. Payment history accounts for a whopping 35% of your overall credit score.
You don’t have to pay your bills in full, but you must make the minimum payment at the very least. This will keep your loans from delinquency. To this end, consider enrolling your accounts in autopay for the minimum payment. That way you’ll stay current — even if your payment due date slips your mind.
Use Credit Responsibly
The second most important detail of a healthy credit score is “credit utilization,” making up 30% of your score. This is the amount you owe compared to the amount of available credit you have.
Let’s say you’ve got $10,000 in available credit across two credit cards. If your total balance is $4,000, your credit utilization is 40%. To keep your credit score thriving, experts recommend that you keep this below 30%.
In other words, don’t max out your credit cards.
Limit Hard Inquiries
Other factors that your credit score weighs are “length of credit history” and “new credit.” Both of these will get dinged when you open a new credit card. That’s because:
- It will lower the average age of your accounts, therefore shortening your credit history.
- It will add to your list of “new credit,” which can temporarily lower your score.
If you apply for new credit only when necessary, you’ll mitigate the number of credit applications (which will help to maintain a good credit score).
Check Your Credit Report Regularly
Finally, you should check your credit report often to ensure there aren’t any errors or fraudulent items. Keeping an eye on your credit score can help you to detect these things, as well. If your score dips suddenly, you can bet something is awry.
You can get credit reports from the major credit bureaus: Equifax, Experian and TransUnion. You can also head to AnnualCreditReport.com for a free annual credit report. If you see anything incorrect, you can dispute those errors and restore your healthy credit.
FAQs About Credit and How It Works
Here are answers to some of the most frequently asked questions about how credit works and why it's important.- What is the difference between a credit report and a credit score?
- A credit report outlines your credit history, showing information like your payment history, credit utilization, collections, etc. A credit score is a simple number that represents your trustworthiness based on the information in your credit report.
- How can I check my credit score for free?
- You can check your credit score for free with sites like Credit Karma which offer free credit monitoring. Many credit cards and banks also offer a free credit score within your online account.
- How long does it take to build good credit?
- The length of time it takes to build good credit depends on your current situation. If you're new to the world of credit, you may have a respectable credit score in as little as a year. If you've got a lengthy but sordid history, it could take years to climb out of that hole and reassume good credit. You can always rebound from any setbacks when it comes to credit.
- Does checking my own credit hurt my score?
- Checking your own credit doesn't hurt your score. Running your credit results in a soft inquiry, which doesn't appear on your credit report. When you formally apply for a loan, you'll receive a hard inquiry that drops your score temporarily.
- What should I do if I have bad credit?
- If you have bad credit, focus on responsible habits with the credit you've got. This includes on-time payments and low credit utilization. If you don't have any credit, consider opening a secured credit card -- just so you can begin showing the credit bureaus that you can use credit responsibly.
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