Credit is the ability to borrow money or access goods or services with the understanding that you'll pay later.
Lenders, merchants and service providers (known collectively as creditors) grant credit based on their confidence you can be trusted to pay back what you borrowed, along with any finance charges that may apply.
To the extent that creditors consider you worthy of their trust, you are said to be creditworthy, or to have "good credit."
How Credit Works
In centuries past, creditors might have gauged your creditworthiness by reputation alone. Obviously, this method was subjective and prone to error, manipulation and bias. These days, creditors prefer a more objective approach. In the U.S., typically they look to your credit history—your record of borrowing and repaying funds—as a first step in determining whether to issue you credit.
Your credit history is summarized in files known as credit reports, compiled by three independent credit bureaus—Experian, TransUnion and Equifax. Banks, credit unions, credit card issuers and other creditors voluntarily report your borrowing and repayment information to the credit bureaus.
Information in your credit report includes:
- The number of credit card accounts you have, their borrowing limits and current outstanding balances
- The amounts of any loans you've taken out and how much of them you've paid back
- Whether your monthly payments for your accounts were made on time, late or missed altogether
- More severe financial setbacks such as mortgage foreclosures, car repossessions and bankruptcies
To help narrow their lending decisions, creditors often use a three-digit number known as a credit score as the first step in deciding whether or not to issue credit. Your credit score distills the information on your credit reports to something that's easy to interpret, and does so in a fair way that minimizes the possibility of bias.
Sophisticated systems known as credit scoring models calculate your credit score by performing complex statistical analysis on the contents of your credit file. Different models, such as the FICO® Score☉ and VantageScore®, calculate scores differently, but all assign higher scores to individuals whose credit histories make them statistically more creditworthy than those with lower scores.
What Are the Types of Credit?
There are four types of credit:
- Revolving credit: With revolving credit, you are given a maximum borrowing limit, and you can make charges up to that limit. You must make a minimum payment each month, but otherwise the amount you pay can be any portion of your outstanding charges, up to the full amount. If you make a partial payment, you will carry forward the remainder of your balance, or revolve the debt. Most credit cards count as revolving credit.
- Charge cards: Once commonly issued by retailers for use exclusively in their establishment, charge cards are relatively rare these days. Charge cards are used in much the same way as credit cards, but they don't permit you to carry a balance: You must pay all charges in full every month.
- Service credit: Your contracts with service providers such as gas and electric utilities, cable and internet providers; cellular phone companies; and gyms are all credit agreements: These companies provide their services to you each month with the understanding that you will pay for them after the fact. Modern credit scoring systems, including the most recent versions of the FICO® Score and VantageScore, can factor your service payment history into your credit scores, but those payments are not always reported to the credit bureaus. The Experian Boost®ø program enables you to share utility and cellphone payment records so they can be considered in credit scores based on Experian data.
- Installment credit: Installment credit is a loan for a specific sum of money you agree to repay, plus interest and fees, in a series of equal monthly payments (installments) over a set period of time. Student loans, car loans and mortgages are all examples of installment credit.
Why Do You Need Credit?
Good credit is necessary if you plan to borrow money for major purchases, such as a car or a home. Or maybe you want to take advantage of the convenience and purchase-protection a credit card can provide.
A higher credit score can mean better interest rates and terms on loans and credit cards. Many card issuers also reserve their most enticing rewards cards for customers with great credit.
Lenders aren't the only ones who concern themselves with your credit reports and credit scores:
- Landlords may check your credit when deciding if they'll rent you an apartment or determining how large a security deposit to require.
- Insurance companies may use your credit scores as factors in determining your rates.
- Utility companies may check your credit before deciding to let you open an account or borrow equipment.
- Prospective employers may use information found in credit reports to make a hiring decision.
- Your credit report can even be used to verify your identity, and for other purposes defined by federal law.
Credit is a tool that can help you buy things you need now and pay for them over time. Establishing and building up good credit over time is an important element of sound financial health.