What Is Credit and Why Does It Matter?
July 17, 2019
Credit can be best defined as an exchange. It's when something of value is exchanged in return for the promise of a payment, usually with interest attached.
Credit simply refers to a situation where something of value such as cash, a home or a vehicle is given in exchange for a promise of payment. When most people think about the term credit, however, they think of a credit rating and whether they have good credit or bad credit.
While credit is a fairly simple concept, in theory, it can be a difficult concept in practice. Credit is a guiding force of our financial lives. It shapes our purchase decisions and our ability to buy homes. It impacts our ability to get auto loans and can even help us qualify for employment.
Unless you have extremely large amounts of cash at your disposal, credit is necessary. Here we’ll cover the types of credit, why it’s important and your credit score.
Types of Credit
Credit can be an incredibly handy and effective financial tool when it’s used responsibly. As our society becomes more cashless and convenient, more ways of borrowing money are cropping up. Here are four ways you can borrow money from a grantor, each of which have their own advantages and disadvantages.
- Revolving Credit: One of the more common types of credit, revolving credit allows you to borrow money up to a certain amount. The lending institution will set a credit limit, often based on your credit score, and revolve the balance by rolling month to month until the debt is paid in full.
As you’re paying back the money, interest charges will typically occur. Each month, the difference between the maximum credit limit and your current balance is available to be borrowed again. Most credit cards like Visa and Mastercard are considered revolving credit.
- Charge Cards: A charge card, different than a credit card, cannot carry a balance. This means it must be paid in full each month. If the balance is not paid on time and in full, penalty fees are often added. Charge cards are mainly for convenience and are advantageous against accumulating credit card debt. American Express is a company that mainly offers charge-cards (although they do offer credit cards now as well).
- Installment Credit: When you take out an installment loan, the borrower loans you a set amount of money and gives you a timeframe to repay it. Interest charges are pre-determined and calculated into set monthly payments. Mortgage loans and auto loans fall into this category, as do personal loans.
- Service Credit: Also known as non-installment loans, service credit loans allow the borrower to pay for a service or membership at a later date. Often, the payment is due the month following the service. Unpaid balances can incur a fee, interest or other penalty charges. If the borrower does not pay, the service is canceled. Many bills like your cell phone, gas, electricity and water bill fall into this category.
Secured vs. Unsecured Credit
It’s important to distinguish between two different types of credit: secured and unsecured. Secured credit describes an exchange where a loan is attached to some type of asset or collateral, such as a home or an automobile. Unsecured credit, on the other hand, is not attached to collateral. This type of credit includes credit cards and charge cards.
Why Do You Need Credit?
In today's credit-driven society, credit is necessary because people rarely have the immediate cash available to make large purchases such as a new home.
While we might fantasize about arriving at a luxury car dealership or a real estate closing with a suitcase full of cash, this isn’t a reality for most people. We pay for a lot of things we need or want with credit. We are then tied to the terms and conditions of paying that money back — whether that be the specific timeframe, the amount of interest or other conditions.
How to Determine Your Credit Score
When someone asks you “How’s your credit?” they are usually referring to the information on your credit report. Your credit report calculates a credit score for you based on the amount of money you’re borrowing or have borrowed from all of your different lines of credit. It then takes into account how you have paid back these debts.
Credit reporting agencies will look at this information to predict the likelihood that you will pay back the money you are asking to borrow. Your past credit history will determine whether you are able to get a loan and, if so, what interest rate you will be offered.
Your credit score also determines a slew of other things besides your ability to get a credit card and a loan. For instance, your credit score can help or hinder your ability to get an apartment. It can also determine your insurance rate, whether or not you will have to pay a deposit when signing up for utilities and more.
What Is a Good Credit Score?
The ability to receive credit is predicated on your credit score. The more responsibly you have managed credit in the past, based on a lender's assessment of your credit history, the more credit you can qualify for.
Credit scores range from 300 to 850. A good credit score will usually be in the 650–719 range. The higher the score, the more easily you will be approved for a loan or a credit card and the lower interest you will need to pay. You can learn all about credit ranges and your credit score here.
Understanding credit can be tricky, but it’s not a new concept. Many people use credit responsibly and it’s helped them secure lower interest rates on loans for the things they need like homes and cars.