What is credit & how does it work?
July 7, 2022 5 min read
Access to credit can be a helpful financial tool. It allows you to make purchases even when you don’t have cash on hand at the moment.
But what exactly is credit? And what does it mean to have “good credit” or “bad credit”? Keep reading to learn more about credit and what it can do for you.
- Credit allows you to get money upfront with the promise to repay it in the future, often with interest.
- Creditworthiness refers to a borrower’s ability to pay what they’ve borrowed.
- Lenders judge creditworthiness in many different ways, and they may use things like credit reports and credit scores to help.
- Credit comes in different forms, including revolving credit and installment credit.
What is credit?
Credit allows you to borrow funds in order to purchase goods and services right away and pay the money back later—often with interest.
But the term can have other meanings.
If you’re wondering whether you have good credit or bad credit, you’re talking about creditworthiness.
It might sound like a buzzword, but it’s pretty important. It’s a term used to describe a borrower’s ability to pay back credit and loans.
Creditworthiness is based on things like credit history and activity. And it can affect approval and the terms of a loan, including fees and interest rates.
One measure of creditworthiness is credit scores. For example, someone with a high credit score may be offered a lower interest rate, because they’re viewed as less risky.
How credit works
Generally speaking, credit works like this: A lender, such as a bank or credit card issuer, approves a person to borrow a certain amount of money.
That money might be available in the form of a line of credit, like a credit card. Or it might be a lump sum, like a personal loan or auto loan.
In exchange for borrowing the money, the borrower agrees to pay it back to the lender, typically with interest.
Types of credit
Credit is often classified in two ways. Whether you know it or not, you probably have used or heard of them before.
Revolving credit is an open-ended form of credit, which means you can use and pay down the credit amount as many times as you like for as long as the account is open and in good standing. Credit cards, charge cards and home equity lines of credit are common examples of revolving credit.
Revolving credit accounts typically have a credit limit, or a set maximum amount that you can borrow at any given time. Each time you borrow money, the amount available to you decreases. And each time you make a payment, your available balance goes back up.
Interest rates vary depending on the type of revolving credit. But with credit cards, you often can avoid interest charges on new purchases by paying off your statement balance on time each month.
Installment credit—also known as an installment loan—is closed-ended. This kind of credit is typically paid back on a fixed timeline, often with interest. And payments usually are for the same amount of money each month.
Mortgages, car loans, student loans and personal loans all are examples of installment credit.
Credit history & credit scores
There are three major companies that keep track of your credit history: Equifax®, Experian® and TransUnion®. If you hear someone talking about credit bureaus, credit reporting agencies or consumer reporting companies, they’re probably talking about these companies.
The bureaus collect information about borrowers’ credit activity from lenders and other sources. That includes things like payment history, credit inquiries and more. That information then goes into credit reports, which in turn are used to calculate credit scores.
Credit score ranges
Credit scores are calculated using mathematical formulas that factor in payment history, length of credit history, credit mix, credit utilization and more. There are multiple credit scores out there. But they all are used to represent creditworthiness.
It may seem confusing to have multiple credit scores from multiple scoring companies, including FICO® and VantageScore®. But figuring out your credit score range can give you an idea of where you stand.
FICO says its scores can generally be judged like this:
- Poor: 300-579
- Fair: 580-669
- Good: 670-739
- Very good: 740-799
- Excellent: 800-850
VantageScore provides these credit ranges as a guide to its scores:
- Very poor: 300-499
- Poor: 500-600
- Fair: 601-660
- Good: 661-780
- Excellent: 781-850
Why is credit important?
Credit is important for a number of reasons. For starters, accessing credit might be the easiest way for you to make a large purchase, such as a car or a home.
And your credit history can play an important role in whether lenders will approve you for a loan or credit card, as well as what interest rate you’ll be charged on the money you borrow.
But banks and lending institutions aren’t the only ones that might consider your credit history. Landlords, insurance companies and even employers are just a few examples of the types of entities that may make decisions based on your credit.
Because credit can play such a huge role in shaping your overall financial profile, it’s important to develop good credit habits. The Consumer Financial Protection Bureau has some helpful tips that can help you build and maintain good credit scores over time.
You can also monitor your credit with CreditWise from Capital One. It’s free to sign up, and you don’t have to be a Capital One customer. And using it won’t hurt your credit scores. You can also visit AnnualCreditReport.com to learn about how to get free copies of your credit reports.
Credit in a nutshell
Because credit can refer to both lending and a borrower’s creditworthiness, it can be a bit confusing. But taking time to learn about it is a positive step. And whether you're looking for your first credit card or rebuilding your credit, using credit responsibly is one key to having good credit.