What is Credit?

What is Credit?

It may seem like everyone is talking about credit and whether theirs is “good” or “bad.” Terms such as credit report, credit score and line of credit may pop up in conversations about credit. But what does this credit lingo mean, and how does your credit behavior affect your financial future?

“Credit allows us to consume today what we can’t purchase today but can pay back over time,” says Rebel Cole, professor of finance at DePaul University in Chicago. “It provides you with financial flexibility.”

You may not have the thousands of dollars necessary to buy a car right now, for example, but if you have a few hundred dollars that can go toward an auto loan payment every month for five years, you can use credit to make the big purchase, Cole says.

When you use credit to spend more money than you currently have at your disposal, you are taking on debt—which is the total amount of money owed. But taking on more debt than you can repay can be risky, Cole says, so it’s important to use credit responsibly—for important purchases or long-term investments, such as a car or a home.

What are the most common types of credit?

There are three main types of credit. These are:

1. Revolving credit: Revolving credit is typically extended by credit card companies. A bank approves a consumer for a line of credit or a maximum that can be spent, and as long as minimum payments are met, the user is in good standing. The line of credit can then be used over and over again.

If you only make the minimum payments on a revolving account, though, you will be charged interest for carrying over your balance—or “revolving” it—to the following month. The higher the balance, the more interest you will be charged. You can avoid paying interest if you repay the amount borrowed in full.

2. Installment credit: Installment credit is when you borrow money and then repay it in equal amounts—usually on a monthly basis—over a specific period of time until both the loan and interest have been paid off. Examples of installment credit include a mortgage, auto loan or student loan.

3. Open credit: Open credit is a type of credit that must be paid in full at the end of the billing period, and neither a finance charge nor interest is charged on the account. A charge card is a common example of open credit.

How do lenders use credit reports and credit scores when deciding whether to extend credit?

The three national credit reporting agencies compile a list of all the credit a consumer has, and that makes up a credit report. A credit report includes information such as bill-paying history, the types of credit accounts opened and any outstanding debt.

Based on the information in your credit report, you are assigned a three-digit number, known as a credit score. Your credit score helps lenders predict how creditworthy you are and how likely it is that you will repay a loan and make payments when they are due.

“It’s an objective third-party assessment of your creditworthiness. If it’s not a financial institution you have a relationship with, they don’t know anything about you,” Cole says, so a credit score provides a way to assess credit risk.

Consumers with scores below 600 may have difficulty qualifying for loans, Cole says, while consumers with scores below 700 will likely be charged a higher interest rate.

“If your report shows blemishes—using credit and not paying it back on time—it’s going to make it difficult to get credit in the future,” Cole says. “Having no credit can be just as bad as bad credit.”

How can a credit score be improved?

If you are working on improving your credit score, Cole recommends ordering a copy of your credit reports to see where you currently stand. Once you’re reviewed your credit reports, address any problems with individual lenders, including repaying any debt. Sometimes, though, the only way to raise a credit score is to use credit more responsibly in the future, Cole says.

“Sometimes there’s nothing you can do but wait for time to pass,” he says. Most negative information will drop off your credit report within seven to 10 years, depending on the type of account.