“Credit” is a term that has many definitions in the context of personal finance. It can refer to the process of borrowing money from a lender and paying it back over time with interest, for example, or it can refer to the financial reputation of a person or company. These definitions are related, as your financial reputation, or your credit history, plays a role in your ability to borrow money.
Another definition, this time in the context of accounting or budgeting, is funds received. For example, your paycheck or a refund deposited into your account would be classified as a credit.
Key Things to Know About Credit
- Credit is an agreement between you and a lender that allows you to borrow money to pay for goods and services and then pay the lender back later, often with interest.
- The types of credit you can get include credit cards and loans, such as auto loans and mortgages.
- Lenders use your credit history, as documented in your credit report, and your credit score to help them determine how much they should let you borrow.
- Making on-time bill payments and maintaining a low balance on your credit cards can improve your credit standing.
- Having credit, especially good credit, is important as it can save you money and open up financial opportunities for you.
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Common Definitions of Credit
Credit can mean many things when it comes to personal finance. You can get a breakdown of the different definitions below.
Borrowing: This is the process of borrowing money from a lender and paying the money back at a later date. Instead of paying for purchases up front with your own cash, you are paying with credit – specifically, the lender’s money given to you with the expectation of repayment, based on your track record as a borrower. Examples of this include using your credit card to buy things like gas and groceries or financing a house or a car with a loan. When you pay back the money you borrowed, you’ll typically pay it back with interest added on top.
Reputation: Your financial standing, or how responsible you appear to be as a borrower, is usually conveyed by factors like your credit score and the contents of your credit report. Lenders and creditors use your credit standing to determine how risky it would be to offer you a loan or credit card. Others, like landlords, employers, and utility companies, may also look at your credit before doing business with you.
Accounting: Credit in the context of accounting refers to funds that you receive. A paycheck deposited to your bank account would be an example of a credit on your household’s balance sheet. The opposite of a credit is a “debit,” which refers to funds that you withdraw or pay with, such as a credit card payment.
Odds are this final definition for credit is a bit less familiar to many folks, considering that only 40% of U.S. adults “have a budget and keep close track of their spending,” according to the National Foundation for Credit Counseling. But you can learn more about the accounting definition of this term from our guide to credits vs. debits.
In this particular guide, we will focus on your credit reputation and the credit you use in lending.
Types of Credit You Can Get
Revolving Credit
Revolving credit is an account with a maximum spending limit and a minimum monthly payment, allowing a balance to be carried from month to month. This is also known as a “revolving” balance. You will typically incur interest on the amount you carry from month to month.
Examples of Revolving Credit:
- Most credit cards
- Personal lines of credit
- Home equity lines of credit (HELOC)
Charge Card
Charge cards usually come with no preset spending limit, which means your purchasing power adjusts with your use of the card. No preset spending limit does not mean unlimited spending, but that your purchases are approved based on a variety of factors including spending patterns, your payment history, your credit history, and others. You generally can’t carry a balance from month to month with a charge card, so the bill must be paid in full each month.
Examples of Charge Cards:
Installment Credit
Installment credit is a loan for a specific amount, which typically must be repaid with interest in specified monthly installments. The interest is usually fixed, and the monthly payments generally stay the same from month to month.
Examples of Installment Credit
- Auto loans
- Student loans
- Mortgage loans
- Personal loans
What Is a Credit Agreement?
A credit agreement allows consumers to borrow money in order to purchase goods or services now and pay later. In exchange for the money supplied on “credit,” or the borrowed funds, a lender can charge interest and fees. Collectively, these costs are referred to as “finance charges.” Finance charges limit the lender’s risk in the event a borrower is unable to pay back what is owed.
What Is a Credit Report?
A credit report is a record of how you have managed borrowing money and paying back debt obligations. Your creditors and lenders report your account information, such as payment history and balances, to the major credit bureaus, and that information is recorded on your credit report.
Others, such as lenders, employers, and landlords, may request your credit report to determine how risky it would be to do business with you or approve you for a credit card, loan, or an apartment. They can also look at your credit score to help make that decision.
What Is a Credit Score?
A credit score is a three-digit representation of all the financial decisions you’ve made in the past seven to 10 years or since you first established credit if it hasn’t been that long. The information in your credit report is used to calculate your credit score. If someone were to ask how good your credit is, for instance, he or she would likely be referring to the category it falls under: excellent, good, fair/limited, or bad. In this sense, credit is measured by the contents of your credit reports maintained by the major credit bureaus and your credit score.
The most popular credit-scoring models range from 300 to 850. A credit score of 700 or higher means you have good credit. A good credit score in turn means you’re a relatively low risk for a lender. You can learn more about why having good credit is important below.
Why Is Good Credit Important?
It’s important to have good credit because it can save you money and give you more opportunities in various areas of your life. You can see a breakdown of the benefits of having good credit below.
- You’re more likely to qualify for credit cards and loans with low interest rates and attractive rewards or perks.
- You can get a higher credit limit than someone with a lower credit score.
- Landlords will be more willing to rent you an apartment.
- You may be able to get a low insurance premium.
- You may not be required to put down a security deposit when setting up utility services.
- An employer may be more willing to hire you.
- You may have better dating prospects, as more than 50% of people say they wouldn’t marry someone with bad credit.
If you want to know where you currently stand, you can check your latest credit score for free here on WalletHub. If your credit score is not where you want it to be, or you haven’t established credit yet, you can use the steps below to build up your credit.
How to Build Good Credit
Get a Credit Card
Opening a credit card account is one of the easiest ways to build credit. Credit cards are easy to get, as you can be approved for a secured credit card if you have bad credit or no credit at all. In addition, you can build credit even if you don’t make any purchases with your card.
Another option is to become an authorized user on someone else’s credit card account. When you are an authorized user, you get to benefit from having positive information added to your credit report without being legally responsible for making payments.
Pay Your Bills on Time
Your payment history is the biggest factor in determining your credit score. Consistently paying your bills on time will have a positive effect on your credit and show lenders you are responsible with borrowed money. However, if you are 30 or more days late on your bills, it can affect your credit negatively.
Keep Your Credit Utilization Low
Your credit utilization is an important factor in determining your credit score. Your credit utilization represents the percentage of your credit limit that you’re using. It’s recommended to keep your credit utilization ratio below 30% to prevent it from significantly affecting your credit score. However, the lower you can get it, the better it is for your credit.
Limit Credit Inquiries
Pretty much every time you apply for credit, a hard inquiry is placed on your credit report, which can temporarily lower your credit score by around five points. When you have multiple credit inquiries within a short amount of time, your credit score can drop even further. That’s why you should limit the number of times you apply for new credit within a short period.
It’s important to note that credit inquiries for an auto loan, student loan, or mortgage made within a 14- to 45-day period will count as a single inquiry, so you can shop around for the best rate.
Monitor Your Credit Report and Credit Score
Monitoring your credit allows you to quickly see if there is any suspicious activity occurring on your credit accounts, which could be a sign of fraud. Fraudulent accounts can negatively affect your credit score and cost you money.
You can keep tabs on your credit by signing up for a free WalletHub account. You’ll get free daily credit scores and reports, personalized money-saving advice, and 24/7 credit monitoring.
Learn more about how to build credit.
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