It is difficult to imagine our financial life without credit. A happy minority can buy a car or even a house right away, but most of us must rely on credit for some of life’s most important purchases.
In addition, everything goes even deeper. Your credit counts when you apply to rent an apartment or request utilities. Sometimes it’s even part of a background check when applying for a job. And in most states, auto insurance companies check your creditworthiness when they put together an offer for you.
So what is credit and how does it work? Read on to find out and find out how to make your credit work in your favor.
What is a loan?
Credit is your ability to borrow money or purchase services or goods on the basis of an agreement to return them under certain conditions. The terms usually include the amount of interest you pay and the payment schedule.
Not all credit accounts work the same, and borrowing terms depend on the type of loan. There are three main types of credit accounts: revolving credit, installment credit and open credit.
Revolving loan
According to Molly Ford-Coates, founder of Ford Financial Management, a revolving loan gives you access to money from a financial institution up to a predetermined limit.
At the end of each billing period—usually a month—you are billed for the balance. You must make at least the minimum payment to avoid fees and damage to your credit. However, if you do not pay your bill in full, you will carry over the balance over the next month and pay interest on it.
“The upside is that the client has the ability to choose how much money he will take each month,” says Ford-Coates. “It can also be a disadvantage if he or she is not a responsible borrower.”
Used properly, this type of account can help you manage your budget and cover unexpected expenses when your reserve fund runs out. However, for longer financial commitments and large purchases, it is usually better to use installment loans due to higher interest rates on credit cards.
The most common examples of revolving credit are credit cards, personal lines of credit, and home equity lines of credit.
Installment loans
“In most installment loans, the money is borrowed and given up front to the client,” says Ford-Coates. “Then the customer must return it within a set period of time.”
Interest and any additional fees associated with the loan are also included in each invoice.
The purpose of an installment loan is to enable the borrower to finance a purchase that they may not be able to pay directly. While installment loan amounts tend to be high, lower interest rates and regular payment schedules make them easier to budget.
Typical examples of installment loans include auto loans, mortgage loans, student loans, and personal loans. Note that interest rates on consumer loans tend to be higher than on other types of installment loans. However, they can still be a good option for emergency spending and debt consolidation.
Open credit
Open credit accounts have no credit limits but require you to pay the balance in full each month. For example, utility bills have different balances each month that you need to pay in full to continue using the service.
Payment cards are also considered open credit accounts. They do not have pre-set spending limits like credit cards – the amount you can charge them can fluctuate depending on various factors such as your credit score, payment history, and more. But whatever you spend, you must pay off the balance in full each month to avoid significant fees or even account closures.
What is a credit report?
Lenders, including vendors, lenders and service providers, determine the terms of a loan to you by assessing your creditworthiness. Simply put, the better your credit history, the better your chances of being approved for a loan on favorable terms.
Your credit history is reflected in your credit report, which is prepared by the credit bureau and reflects how you manage your credit history. There are three main credit bureaus – Experian, Equifax and TransUnion, so you have three credit reports.
Your credit reports contain information such as:
- Credit accounts: This includes all of your creditor-reported debts and related data such as payment history, outstanding balances, and the dates your accounts were opened or closed.
- RequestsA: Every time someone accesses your credit report, they initiate a request. It can be a hard request or a soft request. A hard request usually occurs when you are applying for a loan, while a soft request occurs if someone checks your credit to verify information.
- Personal dataA: This includes your name, address, and employers you mention on your loan applications.
- public recordsA: Your credit reports may also contain bankruptcy information.
What is a credit score?
Credit bureaus use information about your bills and inquiries on your credit report to calculate your credit score. Simply put, a credit score is a three-digit number that reflects a borrower’s ability to repay debt.
“For anyone thinking about using credit, it’s important to know your credit score,” says Andy Murdock, Certified Financial Planner and President of ViviFi Planning. “A lower score can lead to a higher interest rate on your loan and potentially thousands of dollars of additional interest over your lifetime.”
You have multiple credit scores, not only because they are generated from three different reports, but also because there are many scoring models.
FICO and VantageScore are the two leaders in the credit scoring industry and FICO is the most widely used model. You may notice that your VantageScore and FICO scores are different. This often happens because they handle credit data differently when creating ratings.
“Not all credit ratings are the same,” Murdoch says. “In fact, according to the Consumer Financial Protection Bureau, Fair Isaac Corporation, which is the developer of the widely used FICO score, has offered more than 60 different credit scores since 2011.”
However, both the baseline FICO scores and the latest versions of VantageScore use the same range of 300 to 850 points, detailed below:
| Credit rating | FICO score | VantageScore |
|---|---|---|
| very poor | 300-579 | 300-499 |
| Poor | 580-669 | 500-600 |
| Fair | 670-739 | 601-660 |
| Good | 740-799 | 661-780 |
| Excellent | 800-850 | 781-850 |
In addition, FICO also offers industry-specific versions. For example, auto lenders typically use a FICO Auto Score of 8 and credit card issuers a FICO Bankcard Score of 8.
Why is credit important?
Credit gives you financial power, allowing you to buy what you want now and pay for it later. Lenders view your credit as a measure of the likelihood that you will repay the loan.
So it’s important to maintain a healthy credit history so you can get more credit and access the best interest rates and lowest fees, whether you’re applying for a credit card, mortgage, or another type of loan.
Your credit is also important, because these days landlords, employers, and even insurance companies can check it before offering you a home, job, or insurance policies.
bottom line
Credit can sometimes be confusing, but maintaining good financial habits always helps. Take care of your credit health and you’ll be able to enjoy all the benefits of good credit, whether it’s a lower mortgage interest rate or the premium bonus card you’ve always dreamed of.
Editorial disclaimer
The editorial content on this page is based solely on the objective judgment of our contributors and is not based on advertising. It was not provided or ordered by credit card issuers. However, we may receive compensation when you click on links to our partners’ products.
