What is credit and why does it matter?

The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.

Credit is when we purchase an item of value, such as a home or vehicle, and in return promise to make monthly payments until it’s paid off. As a reward for letting us buy now and pay later, the person or company loaning us the money earns a profit through interest payments. 

But some people don’t pay back the money they promised, which puts lenders at risk of losing a lot of money. Starting in the 1970s, with the aid of computers, lenders started keeping digital records of which customers failed to pay their debts and began to share this data with other lenders. Over the following two decades, this data sharing matured into the national credit reporting and credit scoring systems we have today.

Individuals with a good history of paying back their debts typically have better credit and can get loans more easily. Folks with no history of credit usage, or a poor history, may struggle to find a lender willing to lend them money. 

Considering how frequently many American adults buy items on credit these days, it’s important for everyone to understand how credit works and why it matters.

How does credit work?

When you buy something on credit, you make a formal promise to pay for the item in full by a certain date. To reward the lender for the risk they’re taking in giving you the item prior to payment, you pay that lender extra money called interest.

However, not everyone pays back their debts, so lenders get very nervous about which borrowers they can trust to repay them. Your credit reports are a record of the loans you had in the most recent seven to ten years and how successful you were at making payments on time.

More specifically, your credit reports with the main three credit bureaus contain the following types of data:

• How many loans you currently have open, how much you’ve already paid back and how much money you still need to pay back
• Whether you made payments on time and in full
• If you’ve suffered any severe financial hardships such as loan defaults, home foreclosures, auto repossessions or bankruptcies

There’s a lot of data and complexity in each credit report, so to make it easier for lenders to quickly make a credit decision, each report can be summarized into a single credit score (although your score isn’t on your reports, so you’ll have to look elsewhere to see it). Scores usually range from 300 to 850 points, with anything above 650 generally considered good credit.

Those with high credit scores are considered by lenders to be more trustworthy and so are more likely to be approved for loans, receive larger loans and get charged lower interest rates.

Why does credit matter?

Individuals with poor credit struggle to find lenders willing to lend to them for a major purchase. They may find their applications for new credit are often denied. When a customer with poor credit does find a willing lender, they’ll likely get charged a high interest rate, which can make the total cost of the purchase much larger in the long run.

This matters because according to the Federal Reserve, about 77 percent of households have some form of debt, and according to CNBC, the average American owes $90,460 on loans. Total consumer debt in America has recently hit a record $14.6 trillion. These numbers make it clear that most of the major purchases made in America are done on credit. 

It’s important to note that credit reporting and scores are important even for individuals who intend to make all their purchases with cash, because there’s an increasing number of businesses that use credit scores to make decisions about customers.

Employers are looking at credit reports to evaluate the trustworthiness of potential job applicants, and landlords are using credit reports to examine potential renters. Even utility companies, such as cell phone providers, often run a credit check before giving a new customer a contract. 

What are the four types of credit?

As the use of credit grew over time, so did the number of credit products offered by lending institutions. These products can be grouped together into four major types of credit:

• Revolving credit. The most common products of this type are credit cards and home equity lines of credit. The lender specifies a maximum balance they’ll allow a customer to borrow, and the customer is free to use as much or as little of the balance as they choose. Monthly payments are often variable and based on what the balance happens to be at the close of each billing cycle. The balance can be paid to zero and then used again.
• Installment credit. This includes mortgages, auto loans, student loans and personal loans. Customers receive a one-time lump-sum loan and then pay down the balance by making fixed payments each month. Once the balance hits zero, the loan is considered closed. 
  
• Charge cards. This type of credit is most commonly associated with American Express. These products are like credit cards, but they require customers to pay the balance in full every month. On the positive side, they often offer lucrative rewards and have no balance limit. So customers can spend as much as they want, as long as they pay it all off at the end of each month. 
• Service credit. Utility bills, such as electric and gas, are the most common examples of this type of credit, also known as open credit. Customers are expected to pay the balance in full each month, and the payment amount will vary depending on how much of that utility was used that month.

What is secured vs. unsecured credit?

When shopping for credit, it’s important to understand whether physical collateral will be involved. Mortgage and auto loans are considered secured credit because the physical house or car is used as collateral on the loan. In other words, if you don’t pay your mortgage or auto loan, the loan company will come and take ownership of your house (foreclosure) or car (repossession). 

These secure loans usually have a lower interest rate because the lender is confident that seizing the collateral will get most of their money back if you don’t pay your loan.

A credit card is an unsecured loan. If you don’t pay your credit card, the bank can’t come and take away the television you just purchased. As a result, lenders consider unsecured loans to be riskier for their company to offer, so they charge relatively higher interest rates.

How can you build credit?

Most people start out at age 18 with a blank credit history report. Anyone with no credit file must find lenders and utility companies that are willing to offer them a loan. In many cases, a parent or other adult must cosign a loan in order for the lender to feel comfortable giving the person money. This means the cosigner is also responsible if the loan goes unpaid. 

Once a loan is established, the credit history will start to build up. The key to improving your credit is to make all payments on time and avoid opening too many loans at once. If you act responsibly, you’ll prove yourself trustworthy, and that should be reflected in your credit health.

You should make a habit of checking your credit reports regularly to make sure the information on them is accurate, fair and substantiated. If you notice any errors, you can work to address them yourself, or you can get help from a credit repair service like Lexington Law. You can also educate yourself more about credit using our educational resources, like our ultimate credit repair guide.

Reviewed by Vincent R. Mayr, Supervising Attorney of Bankruptcies at Lexington Law. Written by Lexington Law.

Vince has considerable expertise in the field of bankruptcy law. He has represented clients in more than 3,000 bankruptcy matters under chapters 7, 11, 12, and 13 of the U.S. Bankruptcy Code. Vince earned his Bachelor of Science Degree in Government from the University of Maryland. His Masters of Public Administration degree was earned from Golden Gate University School of Public Administration. His Juris Doctor was earned at Golden Gate University School of Law, San Francisco, California. Vince is licensed to practice law in Arizona, Nevada, and Colorado. He is located in the Phoenix office.

Note: Articles have only been reviewed by the indicated attorney, not written by them. The information provided on this website does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client or fiduciary relationship between the reader, user, or browser and website owner, authors, reviewers, contributors, contributing firms, or their respective agents or employers.