What is credit?

Credit is the result of an agreement between a lender and a borrower. It lets the borrower make purchases without having cash on hand. The borrower repays the lender later or over time. Depending on how it’s repaid, there may be a fee called interest added.

Build your financial literacy by learning about the different types of credit and how credit works.

What you’ll learn:

• Credit lets you access funds up front and repay the lender later, often with interest.

• Different types of credit include revolving credit and installment credit.

• Creditworthiness refers to a borrower’s ability to repay what they’ve borrowed.

• Lenders use things like credit reports and credit scores to help judge creditworthiness.

Generally, when you apply for credit, a lender reviews your financial history and decides whether to approve your application. Each lender has policies that help it make decisions about things like the interest rate and how much you can borrow.

If approved, you get the funds in the form of a line of credit, like a credit card, or a lump sum, like an auto loan. 

Repayment options and structure can differ, depending on the credit type.

There are three main types of credit: revolving, open-end and installment. Here’s a look at each.

With revolving credit, you can borrow from the account and pay the money back as long as the account remains open and in good standing. There’s no set end date.

Revolving credit accounts typically have a credit limit, or a 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. 

Credit cards and home equity lines of credit (HELOCs) are common examples of revolving credit. But there are differences in how they’re reported to credit bureaus and how they affect credit scores.

Open-end credit often doesn’t have an end date, so it’s sometimes considered a type of revolving credit. But with open-end credit, the amount borrowed is typically paid back in full at the end of each billing period. 

Because there’s no balance being carried over, some types of open-end credit don’t accrue interest. But with other types of open-end credit, interest typically only accrues on the amount borrowed. 

A charge card is an example of open-end credit. It can be used like a credit card, but balances typically must be paid in full each month to avoid fees or penalties.

Installment credit accounts, also known as installment loans, are closed-end. This type of credit is usually paid back on a fixed timeline and at a fixed monthly amount, often with interest.

Mortgages, car loans, student loans and personal loans are examples of installment credit.

A credit score is a three-digit number, usually between 300 and 850, used to predict how likely a person is to pay their debts on time. Credit scores are a reflection of your creditworthiness, or how likely you are to repay a loan on time. 

Credit scores are calculated using mathematical formulas that factor in things like your payment history, length of credit history, credit mix and credit utilization ratio. You can have multiple credit scores from credit-scoring companies like FICO® and VantageScore®.

Your credit history details how you borrow and use money. If you hear someone talking about credit bureaus, credit reporting agencies or consumer reporting companies, they’re probably talking about Equifax®, Experian® and TransUnion®. Those are three national organizations that track credit history and compile credit reports.

A credit report is a record of your credit history. Credit reports include details like payment history, credit inquiries and other information collected by the credit bureaus.

Credit is important because it can demonstrate to lenders that you practice healthy credit habits. And good credit scores are important because they can increase your chances of qualifying for credit cards, mortgages and auto loans with the best terms.

Banks, credit card issuers and other lenders aren’t the only ones that might consider your creditworthiness. Landlords, insurance companies, employers and utility companies may make decisions based on your credit.

You can monitor your credit with CreditWise from Capital One. It’s free, and you don’t have to be a Capital One customer to use it. Plus, it won’t hurt your credit scores. You can also visit AnnualCreditReport.com to get free copies of your credit reports.

If you want to know about the status of certain credit accounts, your loan or credit card statements are a good place to start.

Credit isn’t just a way to borrow money; it may also refer to credit history and creditworthiness. But no matter how you think of credit, managing it responsibly can be important to your financial well-being. 

Once you’ve got the credit basics down, you can learn how to start building credit or explore how you can use a credit card to build credit through responsible use.