What is Credit?

What is Credit?
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According to data released in January 2018 by the American Banking Association, credit is alive and well. U.S. consumers have a whopping 362 million credit-card accounts, with 92 million of those accounts opened in 2017 alone. But buying on credit extends beyond simply using credit cards; it also includes other types of revolving credit, installment credit, open credit and service credit.

What Is Credit?

Credit is a form of exchange that allows you to obtain goods or use services before you actually pay for them. It can be money that you borrow, which you can actually hold in your hand, or funds that you never see, which are applied directly toward a purchase or a service. Money acquired by credit is not considered income, and it is not “free money;” you are expected to pay it back in exchange for your purchase.

What Is Credit Used For?

Credit is used for safety, convenience and life's unforeseen emergencies. You may feel safer if you carry a credit card instead of large amounts of cash. If your cash is stolen; it’s gone. But if someone steals your credit card, you can cancel the card to prevent unauthorized charges, and receive a new card to use. If you have identity-theft protection as a feature on your credit account, you can have any stolen funds restored to your account by filing an identity theft report with your lender.

Credit is also used as a way to pay for emergencies or even luxuries when you don’t have enough money of your own to pay for these costs. Emergencies fill a diverse spectrum from medical procedures to vehicle repair or replacement. And although luxuries, such as vacations, represent “wants” instead of “needs,” paying on credit means you can take the family to the beach in the summer before your year-end bonus arrives in December to pay for the vacation.

Credit is used to make large purchases, such as your home, and it’s also used for smaller purchases such as clothing, groceries and personal items.

What Is a Credit Score?

A credit score, or credit rating, is a measure of your creditworthiness. The “big three” national credit bureaus (also called credit reporting agencies) – Equifax®, Experian® and TransUnion® – compile and curate data on consumers from lending institutions, creditors, employers and insurers. Among other factors, these credit bureaus look at your payment history, outstanding debt and number of new credit applications you make. Using their internal algorithms to assess your financial health, the credit bureaus then assign a number, which represents your credit score, to place you in a category of credit performance. For example, on Experian’s FICO credit scoring scale, the highest score is 850, which represents an outstanding rating. At the other end of the scale, the lowest score is 300, which represents a very poor rating.

Different Types of Credit

Revolving credit, installment credit, open credit and service credit are the four general types of credit.

  1. Revolving credit accounts, such as credit cards, allow you a maximum credit limit, against which you can repeatedly make purchases as you repay the amount you borrow. A line of credit, which is similar to a credit card, allows you to write a check against the credit limit that a bank or credit union extends to you. If you have a home equity line of credit, your credit limit is approved based on the equity you have in your home; your home is the collateral that secures this type of revolving credit account.
  2. Installment credit accounts, such as loans, provide you with a fixed amount of money that you must repay within a specific time frame. Houses and vehicles are typically purchased on installment credit.
  3. Open credit accounts are loans without limits, which must be fully paid each month. If you travel on business, your business credit card or diner card may be attached to your employer's open credit account.
  4. Service credit accounts allow you to enjoy utilities in your home, such as electricity, gas and water, without paying for them up front. Your utility company extends credit to you as you use their service throughout a month, and then they bill you for this service at the end of your billing period.

Good Credit Habits

The Federal Trade Commission offers tips for developing good credit habits, which will improve your credit score over time:

  1. Pay your bills on time. This is the single most important factor in establishing good credit habits, described by Experian as “most influential” toward a good credit rating.
  2. Keep your outstanding debt below your maximum limit on credit cards and other revolving credit accounts. If your amount of debt continuously hovers near your credit limit, it will negatively impact your score.
  3. Aim for long-term credit health. Building a good credit rating is a marathon, not a sprint. If you do have a short credit history, you can offset its brevity by making payments on time and keeping outstanding balances to a minimum.
  4. Apply sparingly for new credit accounts. If you apply for lots of credit accounts in a short period of time, your credit score may drop.