What Is Credit and Why Is It Useful?
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Credit is defined as an arrangement that allows you to borrow money now and repay it later, plus interest and fees. Credit also refers to your borrowing history, or how you've handled paying debts in the past.
Your credit behavior is recorded on your credit reports, and the information on these reports is used by FICO and VantageScore to calculate your credit score.
Good credit (a score between 690 and 719) makes it easier to borrow money and will likely land you better terms, like lower interest rates, on financial products.
You can build your credit over time with some tried and true practices, such as paying your bills on time every month and using 30% or less of the total credit available to you.
What is a simple definition of credit?
There are a few definitions of credit, but they don't have to be complicated. Credit refers to one of the following:
The ability to borrow money with the promise that you'll repay it in the future, often with interest. You might need credit to purchase a product or use a service that you can’t pay for immediately, like a car, laptop or home repair.
Your financial history, which includes your record of borrowing and paying back money. The information is reported to the three major credit bureaus and appears on your credit reports alongside other information used to calculate your credit score.
What is credit based on?
How you access credit is determined by two things: your credit report and credit scores.
Credit reports
Your credit reports contain a history of your financial behavior, as well as personal information like your employer and current and previous home addresses. The reports list:
The number of open accounts you have, along with the current balances.
Your payment history, including any late or missed payments.
Loans you've taken out and the remaining balances.
Any financial disruptions like a bankruptcy or foreclosure.
Financial institutions can report your activity to some or all three of the major credit bureaus: Equifax, TransUnion and Experian. Each bureau produces a credit report that you can access for free by using AnnualCreditReport.com.
Monitoring your credit reports and looking for discrepancies is a good habit to create. If you find an error, you can dispute it with the credit bureau. If an investigation is ruled in your favor, the fixed error could have a positive impact on your credit score.
Credit scores
Your credit score is a three-digit number typically ranging from 300 to 850. It distills your credit history and other components of your credit report into a shorthand used by financial institutions to determine your creditworthiness. Your credit score is not found on your credit reports.
FICO and VantageScore are the two major companies that calculate credit scores, and they apply different weights to some of the major factors that impact your score. The combination of multiple scoring companies and slightly different scoring methods mean you will have a few different scores, but it’s nothing to worry about.
Your credit score rarely stays static, so fluctuations of a few points up or down usually aren’t anything to be concerned about. Larger drops of 10 points or more can be a sign that something has gone wrong — maybe you missed a payment or someone is using your information to open accounts. If this happens, grab a copy of your credit reports to assess the situation.
What is credit used for?
Credit comes in many forms. You might need credit to purchase a product or use a service that you can't pay for immediately, like a car, home, furniture or cell phone. Student loans are a type of credit that you promise to pay back when you graduate.
You must apply for credit, and the amount you're authorized to use is determined by lending institutions (like banks or mortgage companies) based on your personal financial history. For example, when you apply for a credit card, the lender takes your financial behavior into account before determining your credit limit. A higher limit suggests you are responsible enough, in the lender's eyes, to pay a large sum back, while smaller limits might be reserved for people who are either new to credit or rebuilding it.
Types of credit
There are many types of credit, but two are most popular: revolving and installment credit.
Revolving credit
Revolving credit is a type of credit, typically issued in the form of a credit card, where users are given a credit limit but can spend as much or as little up to that amount as they want. Balances are paid off in full or in part each month, and any remaining balance is carried over to the following month, usually with interest on the unpaid balance. Credit cards are different from charge cards — another type of credit — where the balance must be paid in full each month.
Installment credit
Installment credit is a type of credit, usually issued in the form of a loan, that borrowers pay back in steady increments over time. Examples of installment credit include student loans, car loans and mortgages.
Service credit
Service credit is a type of credit that describes contracts you enter into with many service providers, like utility companies and membership services. These companies provide the service and you sign a contract to pay them after the fact. Your cell phone plan, electric bill and gym membership all fall into this category.
Why is having good credit important?
Think about good credit as a gateway to building the kind of life you want. Most people can’t pay for everything they want or need in cash, so taking the time to cultivate your score can open doors and make achieving financial goals easier.
How to build your credit
Whether you’re starting from scratch or want to build stronger credit, here are a few strategies to get you going.
If you don’t have credit but are looking to build it
Become an authorized user on the account of a trusted family member or spouse who has a long, responsible credit history. By having your name attached to their line of credit, you can reap the benefits without worrying about the responsibility of payment.
If you can’t get a credit card because you have limited or bad credit, try a secured card. These cards require an upfront deposit, and lenders can take that deposit back if you don’t pay the balance in a timely manner. After you’ve established a history of paying on time, you can look into upgrading to an unsecured card.
Try a credit-builder loan, where lenders hold the money you pay in an account until the full amount is repaid, then release it back to you. Look for credit-builder loan opportunities at your local credit union or community bank.
If you have credit but want to strengthen your score
Be sure to make payments on time. Make at least the minimum payments to avoid being hit with a penalty.
Keep your credit utilization low (under 30% is good but less than 10% is ideal).
Keep credit accounts open, especially your most long-standing accounts. Your credit history takes into account your average account age, so it's a good idea to keep your first credit card open (even if you don’t use it much now).
Don’t apply for too many lines of credit at once. NerdWallet recommends spacing credit applications about six months apart.
