Credit | B2B Finance Glossary
What is Credit?
In its most basic sense, credit is the ability to borrow money or access goods and services with the understanding that you will pay for them later. Lenders, merchants, and service providers will grant credit based on how confident they are that you will pay them back what you’ve borrowed and any other charges that may be added. If creditors believe that you are trustworthy, you are known as creditworthy. In other words, you have good credit.
How Does Credit Work?
Before the credit system, creditworthiness was determined by reputation alone. This method could easily become prone to errors, manipulation, and biases. Today, in the US, creditors will look at a potential customer’s credit history to determine whether or not they will issue a line of credit to that customer.
Credit history is each borrower’s record of borrowing and repaying funds, and this history is summarized in files known as credit reports. These files are put together by three independent credit bureaus: Experian, Equifax, and TransUnion. Creditors, such as banks, credit card issuers, and credit unions, will voluntarily offer your borrowing and repayment information to these credit bureaus so they can create your credit report.
Here’s what’s included in your credit report:
- The amount of loans you have taken out and how much of these loans have been paid back
- Any severe financial setbacks such as bankruptcies, mortgage foreclosures, and car repossessions
- The number of credit card accounts you have, their borrowing limits, and your current outstanding balances
- How timely your monthly payments are, and whether or not you’ve missed your payments
What is a Credit Score?
Creditors use a credit score to help them narrow down their lending decisions. This three-digit score summarizes the information on your credit reports into something much simpler to interpret. On top of this, your credit score distills your credit report information in a way that is free of bias.
Credit scoring models are sophisticated systems used to calculate your credit score by performing complex statistical analysis on the information in your credit file. It’s important to note that there are different models, including the FICO Score and VantageScore, and each of these models calculates scores differently; however, they all assign higher scores to individuals whose credit histories make them statistically more creditworthy than those with lower scores.
What Are the Different Types of Credit?
There are four different types of credit in total:
- Charge cards: Charge cards are not as popular as they used to be, but some retailers still issue them. Charge cards are used in a way that’s similar to a credit card, but they do not allow the holder to carry a balance: you have to pay off every charge in full each month.
- Installment credit: Installment credit is a loan for a specific amount you agree to repay on top of interest and fees in a series of equal monthly payments over a predetermined time. This type of credit gets its name because payments are made in agreed-upon installments until the amount is paid in full. Examples of installment credit include student loans, car loans, and mortgages.
- Revolving credit: Most credit cards fall under the revolving credit sector. This type of credit gives borrowers a maximum borrowing limit. Once the limit is hit, the borrower cannot make more charges. Additionally, you must make a minimum payment each month, pay a larger sum than the minimum payment, or pay the total amount that has been borrowed. If you make a partial payment, you will carry forward the remainder of your balance – in other words, you will revolve the debt.
- Service credit: Service providers such as gas, electric, cable, internet, cellular services, and gym memberships all operate as credit agreements. These companies all provide products and services with the faith that you will pay for them afterward. Credit scoring systems such as FICO Score and VantageScore can factor your service payment history into your credit scores, but these payments are not always reported to the credit bureaus.
Why is Credit Important?
Good credit is necessary when you want to borrow money for major life purchases, such as a vehicle or a home. However, good credit is also essential in other aspects of life: it allows you to get better interest rates and terms on loans and credit cards and even better reward systems for the credit cards you can access. Landlords, insurance companies, utility companies, and even prospective employers consider your credit history when making decisions about how they want to engage with you. Credit is an essential tool that can be used to build up your financial health and increase the quality of your life.