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Understanding Credit: What It Is and How It Works

Credit is the ability to borrow money or obtain goods or services with the promise of paying for them later, typically with interest.

What is Credit

Credit is a way to allow people to purchase items, without actual cash, with a promise to pay at a later date typically with interest. If the item purchased on credit is not repaid, the borrower risks some type of penalty like late fees or legal action.

How Credit Works

When a business extends credit, it’s generally documented using a legal contract. That legal contract generally states the borrower’s promise to repay with costs, fees and terms spelled out.

How Credit is Extended

Lenders, such as banks and credit card companies, use your credit history and scores to evaluate the creditworthiness of borrowers; unless you have no credit history established yet. What they’re really considering is the likelihood you’ll repay the extended credit in a timely manner.

What’s in a Credit Report

Your credit history is contained in a credit report, unless you have no credit history. Credit reports show your creditworthiness using payment history on credit accounts, the amount of debt you have, and the length of your credit history.

The credit history contained in credit reports helps to calculate a credit score. The lender will use this information to determine your credit score. Your credit score is a number between 300 and 850, with a higher score indicating that you are a good credit risk.

If your credit score is good, you will likely be approved for a loan or other form of credit at a lower interest rate. This can save you money over the life of the loan.

How credit scores are calculated.

Credit scores are calculated based on several factors:

  • Payment history
  • Credit utilization
  • Length of credit history
  • Types of credit used
  • New credit inquiries

There are three major credit bureaus in the United States that collect information about your credit history, including your credit accounts, payment history, and debt levels.

  • Equifax
  • Experian
  • TransUnion

Common Types of Credit

There are two main types of credit: revolving and installment.

(1) Revolving credit allows you to borrow up to a certain limit and make payments based on the amount you borrow:

  • Credit cards – Credit cards are a common example of revolving credit that allows you to borrow money up to a certain limit and pay it back over time, typically with interest.
  • Lines of credit – Lines of credit are similar to credit cards, but they have a higher credit limit and can be used for a variety of purposes.

(2) Installment credit involves borrowing a set amount of money and making fixed payments over a set period of time:

  • Mortgages – Mortgages are loans used to buy a home. The loan is repaid over a period of 15 or 30 years, with interest.
  • Car loans – Car loans are loans used to buy a car. The loan is repaid over a period of 3 to 7 years, with interest.
  • Personal loans – Personal loans are considered an installment loan that is repaid in equal installments over a set period of time. The borrower receives the entire loan amount upfront, and then makes monthly payments that include both principal and interest. The interest rate on an installment loan is typically fixed, meaning that it does not change over the life of the loan.

Benefits of having good credit

There are many benefits to building good credit. Good credit can help you:

  • Get approved for loans and credit cards
  • Get a lower interest rate on loans and credit cards that enables you to save money
  • Rent an apartment or house
  • Get a lower insurance premium
  • Easier to get approved for credit
  • Better insurance rates
  • More job opportunities

Managing credit responsibly is crucial for maintaining good credit and financial stability. Make paying your credit obligations on-time a habit and always keep revolving credit balances like credit cards at a minimum. Check your credit reports once a week for free to ensure that all information is accurate and up-to-date.

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