How Credit Works

What is Credit?

By Saphia Lanier
Reviewed by Lauren Bringle, AFC®

What exactly is credit? Credit is receiving something of value now with the promise to pay for it later. Think about it this way...

What financial goals do you hope to achieve before you're 30? Or better yet, before you retire?

Many Americans are looking forward to owning a home, buying a car, or even a boat one day. But unless you strike it rich, you're going to need to use credit to qualify for financing to purchase these items.

And the same holds true if you want to do other common "adulting" things, such as renting an apartment or buying a mobile phone service.

If you're not already familiar with credit and how it works, you're not alone. One survey shows most Americans don't know how common actions can affect their credit scores. [1]

But we've got you covered. Read on to get a better understanding of everything to do with credit.

In this article

So what is credit and how does it work?

In a nutshell, credit refers to your ability to get approved for a loan, credit card, or other forms of financing. Lenders will check your credit history to determine whether or not you're credit-worthy. So you'll need a good credit history to improve the odds of getting approved (with a favorable interest rate).

You can establish credit history by entering into a credit agreement with a lender, where you'll be responsible for repaying $X within X months/years. Your payments are broken up into monthly installments, which will accrue interest over time (so repaying a loan faster than the term will lower what you owe). This is a common scenario when you take out a loan with a bank.

Another common credit account scenario is when you use a credit card.

When building your credit, you'll need to keep an eye on your credit report and credit score.[2] Your credit report is what shows the credit accounts you have opened, closed, or in delinquent status. And based on your credit report (and how good or bad it is), you'll receive a credit score. But more on that in a minute.

Your credit matters because it can determine whether or not you're approved for an apartment, used car loan, or even a bank account.

For example, some landlords will only rent to tenants with a 650 or higher credit score and no evictions on their credit report. Others may still rent to you without these criteria, but then you'll have to pay a higher deposit to move in.

What is a credit score?

Your credit score is a number assigned to you based on what's in your credit report. There are various factors used when calculating your credit score. Now, where things can get confusing is the various scoring models used by different financial institutions.

Lenders, creditors, and landlords typically have a minimum score for automatic approval. Anything lower will require additional deposits, documents, or arrangements.

Where the creditor pulls your credit from will determine the score they see. For instance, on platforms like Credit Karma, you'll find a credit score based on the VantageScore 3.0 model (VantageScore 4.0 is now here).[3] Then some banks choose to use FICO® Score 8 model.[4] This is also what the three major credit bureaus use to determine your credit score.

Quick Note: Your VantageScore is typically higher than your FICO score.[5]

cfpb Credit-score-explainer

Source [6]

There are different credit score ranges to identify whether you have excellent or poor credit. You'll also find some scoring models have lower and higher thresholds. For example, the FICO Score 8 issues scores between 300 and 850, while FICO Auto Score goes from 250 to 900.

The FICO 8 model looks like this:

experian-different-score-ranges

SOURCE [7]

What is a credit report?

You can think of your credit report as a report card of your finances. It keeps track of all your debt-related accounts to determine whether you're a trustworthy borrower.

There are several ways an account can show up on your credit report:

  • You applied for credit (hard credit inquiries)
  • You opened a line of credit with a lender (payments missed/made)
  • You receive a tax lien, bankruptcy, civil judgment
  • You miss payments on rent, utilities, and other bills, and it's reported
Your credit report shows all open and closed accounts and whether they're in good standing, overdue, or delinquent. The better you are at paying things on time, the better your credit report (and score) will be.

Here's an overview of what you'll find on your credit report:

You can obtain your credit report for free from each major credit bureau — Transunion, Equifax, and Experian.

What is the difference between credit and debit?

When you open a checking account with a bank, they issue you a debit card to withdraw money from the ATM and pay for goods online or using a card reader (like at the supermarket).

However, when you apply for a credit card with your bank or other card issuer, you'll receive what's called a credit limit. If it's a secured credit card, then you'll have to put some or all of the money on the card upfront.

For example, you may have to put down $99, and then the bank will add the rest, totaling a $500 credit limit. Some banks will do this or ask you to put the entire $500 on there, so your money is the collateral if you don't manage your account responsibly.

Each time you use a debit card, the money is removed from your checking account. The money comes from funds you deposit as cash, check, or direct deposit (such as from an employer). Once your funds run out, then you can no longer use the debit card until you add more money to the account.

When you use your credit card, the money that's withdrawn has to be repaid. You have the option of either repaying it all at the end of each billing cycle. Or you can pay a minimum balance.

If you choose the latter, then the remaining balance on the card will accrue interest.

For example, let's say you have $500 on your credit card and you use $400 for that month. When your bill comes, you can either pay back the full $400 without credit card interest. Or you can just pay $50, and the remaining $350 will have 22% interest added to the total each month until you pay it back in full.

If you take six months to repay this, then you'll end up paying several hundred dollars on top of the $300 you borrowed initially. So it's wise to pay off your balance as quickly as possible.

What are the different types of credit?

One of the factors determining your credit score is having a good mix of credit types in your credit report. So simply having 5 credit cards isn't going to get you the best credit score possible.

You need to balance out your credit history with different types of credit to show you can handle various forms of financing.

Here's a look at the different types to add to your credit profile.

Installment credit

An installment loan is a loan you repay over time through monthly payments. Examples of installment credit include student loans, auto loans, business loans, personal loans, and mortgages.

With an installment loan, a lender agrees to lend $X to you, which must be repaid in X months. For instance, you may borrow a car loan for $15,000 and have 36 months to repay it. Your monthly installment payments will be $416 plus interest.

Revolving credit

Revolving credit accounts allow borrowers to continuously reuse the money lent to them, as long as they repay the balance in full. Examples of revolving credit include credit cards, retail credit cards, and home equity lines of credit (HELOCs).

Let's say you have a credit card limit of $1,500 — you can choose how much or how little you use. One month, you can choose to borrow $1,000 and repay the credit card balance in full over two months ($1,000 plus two months of interest). Then with your limit back to $1,500, you decide to only borrow $500 for the month. You repay it back in full without interest.

Why do you need credit?

Being able to qualify for loans and credit cards sounds great — but is managing your credit something you should be doing? Is it really worth it?

Well, credit is about more than getting financing. If your credit is poor, you'll have to deal with getting denied apartments or paying higher deposits just to move in. Or if you want to rent a car with bad credit, then you'll have to pay a higher deposit plus the rental price.

Learn about the high cost of bad credit.

Then if you decide to apply for credit or financing, you'll find your insurance rates may be much lower when you have decent credit. In fact, those with excellent credit scores can receive loans with 0% interest at the start of the loan's term.

But let's say you're approved for a high-interest auto loan with a low credit score. When you put auto insurance on it, you can expect it to be much higher because of your poor credit.

Aside from financial products, poor credit can hurt another area of your life — employment. Some employers today are checking applicants' credit histories and using that to determine whether or not to hire them.

So if you think about it, having good credit could make life easier (and cheaper).

How do you build credit?

Building credit from scratch isn't difficult to do. However, it does require consistency and commitment. You can't expect to establish and raise your score overnight. It takes time to build credit (how long depends on your credit report and how responsible you are). To start from scratch, you may need to do things like apply for secured credit cards and installment loans, pay your bills on time, and keep your credit balances low (preferably below 20% usage).

You can even piggyback someone else's excellent credit by becoming an authorized user of their account.

There are also alternative methods you can use, such as reporting your rent and utility payments. Or getting a credit builder loan, which is a great way to add a mix of accounts to your report (this is an installment loan).

Learn how to build your credit.

Bottom Line

Understanding how credit works will empower you to make better financial decisions. This way, you can apply for financing, jobs, and places to live without the worry of denial.

Hopefully, this guide and its resources will help you build your credit so you can enjoy the freedom and benefits it can bring.

Need to build your credit? Self provides a step-by-step credit building process that could help you do just that. Learn more at self.inc

Sources

  1. Nerdwallet
  2. USA.gov
  3. VantageScore
  4. Fico 8 model
  5. HSH
  6. Consumer Financial Protection Bureau
  7. Experian

About the author

Saphia Lanier is a content writer with 14 years of experience writing on topics relating to SaaS, marketing, SMBs, and business/personal finance. See Saphia on Linkedin.

About the reviewer

Lauren Bringle is an Accredited Financial Counselor® and Content Marketing Manager with Self Financial – a financial technology company with a mission to help people build credit and savings. See Lauren on Linkedin and Twitter.