It is a valuable financial tool that can enable you to make purchases even when you do not have immediate access to cash.
What is a Credit?
Credit is a financial term that refers to the borrowing of funds that are expected to be repaid within a specified period of time. It is essentially an agreement between two parties where one party (the borrower) receives funds from the other party (the lender) with the expectation of paying it back, often with interest.
Credit is an integral part of modern society as it enables individuals and businesses to acquire assets, purchase goods and services, and invest in opportunities that they would otherwise be unable to afford. Credit allows individuals and businesses to spread the cost of expensive items over a longer period of time, making it easier to manage their finances.
Credit can come in many forms, such as credit cards, loans, mortgages, and lines of credit. Each of these has its unique features, but they all involve borrowing funds with the expectation of repaying them over time.
Credit cards, for example, are a popular form of credit that allows individuals to purchase goods and services on credit. They offer a revolving line of credit, which means that the borrower can use the available credit repeatedly as long as they repay the outstanding balance. Credit cards often come with high-interest rates, so it is essential to use them responsibly and pay off the balance on time.
Loans are another common form of credit. They are typically used to finance large purchases such as a car or home. Loans come with a fixed interest rate, and the borrower must make regular payments over a set period to repay the loan. Failure to repay the loan can result in the lender taking legal action to recover the funds.
Mortgages are a type of loan that is used to purchase a property. They typically come with a long repayment period, which can last up to 30 years. Mortgages often have lower interest rates than other forms of credit, making it more affordable for individuals to buy a home.
Lines of credit are a flexible form of credit that allows the borrower to access funds as needed. The borrower can draw on the line of credit whenever they need to, and they only pay interest on the amount that they have borrowed.
Understanding the Mechanics of Credit
In the past, creditors used subjective measures to determine an individual's creditworthiness, leading to inaccuracies and biases. However, in modern times, creditors rely on more objective methods. In the United States, credit history is the primary factor used to evaluate an individual's creditworthiness.
Credit history is documented in credit reports generated by three independent credit bureaus: Experian, TransUnion, and Equifax. Banks, credit unions, and credit card companies voluntarily report their clients' borrowing and repayment data to these bureaus.
Credit reports contain information such as the number of credit cards held, the limits and balances on these cards, outstanding loan amounts, and payment histories, including whether monthly payments were made on time or missed. More significant financial setbacks such as mortgage foreclosures, car repossessions, and bankruptcies are also documented.
To simplify lending decisions, creditors use credit scores, a three-digit number that provides a quick overview of an individual's credit history. Credit scoring models, such as FICO Score and VantageScore, calculate credit scores based on complex statistical analyses of an individual's credit file. These models assign higher scores to individuals with credit histories that demonstrate their statistical creditworthiness.
Understanding Different Types of Credit
Different types of credit are available to suit various needs and preferences.
Here are the four most common 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 the amount you pay can be any portion of your outstanding charges, up to the full amount. Revolving credit is often used with credit cards.
- Charge cards: Charge cards are similar to credit cards, but they require you to pay off the entire balance every month. These cards are rare nowadays, but some retailers still offer them.
- Service credit: Contracts with service providers such as utilities, cable and internet providers, cellular phone companies, and gyms are all examples of service credit. You use their services each month, and they expect you to pay for them after the fact. Your payment history with service providers can also affect your credit score.
- 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. Car loans, mortgages, and student loans are common examples of installment credit.
When a borrower applies for credit, the lender will review their credit history and financial information to determine how much credit they are willing to extend.