What Is Credit, How Does It Work, and Why is Credit Important?
Have you ever wondered what the “credit” part of “credit card” means? It’s easiest to think of credit like a short-term loan, but it’s a bit more complicated than that.
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Credit is Borrowed Money
“Buying on credit” means using borrowed money from a lender, most often through a credit card. Essentially, by buying an item on credit, you agree to pay back the lender at a later date. In the case of credit cards, you have a monthly payment, with a minimum you need to pay. There will also be an interest fee on any credit you have not paid back by a certain deadline.
How Credit Works
If you spend a total of $100 worth of credit, and pay off a minimum of $30, you’ll have $70 worth of debt left over. But, even if you don’t use the card at all by the time the next month’s payment is due, you’ll still owe more than $70. If you have a 15 percent interest rate, you will owe $80.50. If you fail to make minimum monthly payments, your interest rate (also known as an annual percentage rate or APR) could go up drastically.
Types of Credit
- Revolving credit. The credit card in the above example falls under this category. You are given a credit limit, usually based on your credit score, the maximum amount of money you can borrow against on that line of credit. You carry over the balance of whatever you don’t pay month to month.
- Charge cards. While similar to revolving credit cards, instead of carrying over a balance, you must pay off the full balance every month.
- Service credit. This covers service providers, such as your utilities, cell phone, gym membership, and more. Not all service credit accounts show up in your credit history, but all are agreements to pay each month, or the service could end.
- Installment credit. A creditor will loan you a specific amount of money, which you then pay back in installments over a set time, with interest. Car loans and mortgages fall under this category.
Why Credit is Important
Your credit score represents your ability to pay back loans, including credit cards. By making payments on your credit card, your credit score will go up. Why does that matter? Expect your credit score to be checked by potential employers, landlords, or other credit lenders. The higher your credit score, the more likely you are to get the lowest interest rates.
Credit is also important in that it allows you to buy things that you don’t have the full cash amount for. As noted earlier, both car loans and mortgages are often bought on credit. In the case of houses, it’s rare that the average person has hundreds of thousands of dollars in cash they can use to buy a house outright. Being able to have a mortgage could mean being able to afford a house. Or, if your bank account is low, but you still need groceries and won’t see your paycheck until next week, you can buy the groceries on credit. It’s essentially a way to defer payment, though thanks to interest, you will pay more for the items in the long run.
Credit, and by extension your credit score, is important as it affects your overall purchasing power. It can help you out in a tight spot, or can enable you to make a large purchase and pay it off over time. The better your credit score, the less interest you will pay. Ready to learn more about credit scores and credit cards? Visit our Credit Score Resource Center and Credit Card Learning Center. Is there an inaccuracy on your credit report? Learn how to dispute at our Letter Template Resource Center.
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A former newspaper journalist, Cole spends his free time reading, writing, playing video games, watching movies, and learning about every subject under the sun. He lives with his wife and daughter in Idaho. Follow Cole on Twitter: @ColeMayer42
This post was updated February 28, 2019. It was originally published March 8, 2018.