Credit is something that many people have some misconceptions about, although it is one of the most important financial factors to consider.
It is a concept that has existed long before credit cards, as a way to keep record of individual financial responsibility, yet most are unsure of what it is or how it works. Over the years, credit has evolved and become a central measure of how responsible someone is with the money he or she borrows, and how much of a risk a financial institution is taking when it agrees to lend fund to someone.
Credit is necessary for life’s more important purchases. Buying a car, renting an apartment or buying a home will require financing unless you can pay for these large items with cash. Understanding how credit works and how to build it is important when learning about personal finances and in planning a healthy financial future. Read on to learn more about credit and how it affects your finances.
What Is Credit?
Credit is an individual’s ability to borrow money and the amount he or she can borrow to pay for goods and services when they are needed. A grantor gives credit to a consumer, who in turn agrees to pay back the amount spent, along with any finance fees, at a specified time. In the past, individual store owners, such as grocers, would grant credit to families, allowing them to purchase goods they would pay for later. Today, credit is controlled by large banks and is used through credit cards and other loans.
There are four different kinds of credit:
- Installment credit – When a creditor loans a consumer a specific amount of money, which is paid back with interest in installments of fixed amounts, the consumer is using installment credit. Examples of this kind of credit are car and mortgage loans.
- Service credit – Service providers, such as utility and mobile phone service companies, issue service credit to their customers. They provide a service that will later be paid by the customer.
- Revolving credit – This type of credit is extended by lenders and remains the same month to month. The consumer is free to use as much or as little of their credit limit as they wish, and his or her unpaid debt carries over to the following billing period. Most credit cards are a form of revolving credit.
- Charge cards – The credit that charge cards offer is similar to that of credit cards, but the balance on the card does not carry over and must be paid every month. Charge cards are increasingly difficult to find, as fewer companies offer them.
How Credit Works
Credit is given to consumers by financial institutions in various forms, including credit cards and loans. To establish credit, an application is filled out for the account desired with the chosen lender. Lenders use provided information, such as a Social Security Number for identification, and to search for the borrower’s credit history. The three major credit bureaus, Equifax, Experian and TransUnion, keep record of an individual’s credit history and issue a credit score based on that history. Once a lender has determined whether or not the applicant is trustworthy based on their credit history or score, it makes a decision to extend credit to the borrower or deny the application.
If a lender decides to offer an applicant credit, it then establishes guidelines for use of that credit, such as a maximum limit on how much can be borrowed. Borrowers can be limited to a one-time use of the credit with a loan, or can be given a monthly limit, known as a credit limit or credit line. The terms provided for the account also outline the payment plan and the penalties for exceeding the set credit limit and for late payments. The lender may also provide a means by which the borrower can use that credit, such as a credit card, depending on the type of credit the lender extends.
When lenders determine a potential borrower’s trustworthiness, they most likely use the applicant’s credit score. A credit score is a three-digit number that is generated by a program that reads individual credit reports. Most lenders have a range they use to determine eligibility for credit, making credit scores easy for them to interpret on a case-by-case basis.
The most commonly used credit scores are FICO credit scores, which are determined by the three national credit bureaus. FICO scores fall anywhere between 300 and 850, and are different according to each bureau, so every consumer has multiple credit scores. Knowing how to check credit scores is important in maintaining a healthy financial life, and there are several ways scores can be checked for free. There are several factors that affect a credit score, such as late or missed payments.
There are several kinds of credit cards available to consumers, each offering different benefits to card holders. Credit cards are a convenient way to use and build credit. Making payments consistently every month, avoiding late fees and staying within the credit limit are ways to improve a credit score using a credit card.
Choosing the right credit card is important, as not all credit cards offer the same terms and benefits, and therefore do not fit the needs of everyone. Some of the types of credit cards available to consumers are:
- Balance Transfer cards
- Cashback cards
- Low-interest cards
- Business cards
Debt can happen to anyone, so taking the necessary steps to avoid or get out of debt is important. Credit counseling is a great tool for a variety of financial needs. Credit counseling agencies are nonprofit organizations dedicated to educating consumers on financial management strategies and helping clients manage and pay back their debts.
These agencies offer counseling sessions for those who are considering bankruptcy or buying a home, and set up debt management plans for those who are struggling with their consumer debt. Unlike other debt relief services, reputable credit counseling agencies are accredited and certified by various financial organizations, and offer free educational materials and low-cost debt relief services.