What Is Credit?

There are three little words you’ll probably hear time and time again as you approach major financial milestones in life: “You need credit.” Interested in a credit card so you don’t have to carry around a lot of cash? “You need credit.” Looking to buy a car? “You need credit.” Want to own a house? “You need credit.” And, while most people probably have a base understanding of what that means — you’ll need to borrow money, of course — they many not understand the ins and out of credit and why their credit reports and credit scores are so important. Well, we’re here to break it all down.  

What Is Credit?

Simply put, when you pay “by credit,” you are borrowing the money you need to make purchases. In exchange for that financing, you generally agree to pay the lender back the amount you spend or borrow, plus interest. Here are a few of the most common ways we use credit:

• You are using credit when you make purchases with a credit card or charge card at a retailer and pay your credit card or charge card bill later.
• You are using credit when you borrow money to buy a home or car and pay back the amount you borrow, plus interest, in monthly payments to the lender.
• You are using credit when you take out a personal loan to consolidate debt.

While all of these examples involve using credit, their borrowing terms aren’t exactly the same. Here is a closer look at three major types of credit accounts.

1. Revolving Credit.  With a revolving credit account, you are not required to pay the bill in full each month. A revolving account enables you to revolve the spending that you make from month to month. You are charged for the money you borrowed to make purchases you didn’t pay back in full, plus finance charges for rolling over the debt from month to month. Credit cards are revolving credit accounts: You are given a credit limit for your spending, but you are only required to pay the minimum back at the end of the month. If you carry a balance, you will pay interest. If you pay that balance down, the credit that you were using will become available to you again.  
2. Charge Cards. Charge cards are similar to credit cards, in that you borrow money (up to a pre-set credit limit) to make the purchases and pay a bill to your lender or creditor later. The key difference is that with a charge card you must pay the account in full each month.
3. Installment Loans. These loans have a fixed number of payments over a fixed number of months at a set interest rate. With an installment loan, you borrow a certain dollar amount from a lender and agree to pay the loan back, plus interest, in a series of monthly payments. Auto loans, mortgages, student loans and home equity loans are all examples of installment loans.

Do the Types of Credit Matter?

Yes, for two major reasons. First, it’s important to know what you’re signing yourself up for. You’ll want to understand the terms and conditions of each loan you apply for. You’ll want to pay particular attention to how that loan is to be repaid, since payment history is the most important factor among credit scores.  

Speaking of credit scores, it’s important to have a mix of revolving accounts and installment accounts on your credit reports in order to show creditors that you can handle both types of credit. The types of accounts in your credit file make up 10% of your credit score. You can learn more about what goes into your credit score here.

What Is My Credit?

There’s a good chance you’ve been asked, “How’s your credit?” at some point in time. And, while the answer technically involves the money you’re borrowing and all your different credit lines, the inquisitor is most likely referencing the information on your credit report. Your credit report is a complete compilation of all the loans your currently have or have had in the past. They’re compiled by the credit reporting agencies, and are used primarily by lenders to assess the likelihood that you’ll pay back the money you’re asking to borrow as agreed. Your credit reports are also used when a lender wants to calculate your credit score. That score can determine whether you get a loan and, if so, what interest rate you’ll be offered.

Why Is Credit Important?

In addition to affecting your ability to secure affordable financing for all those major milestones we mentioned, your credit report and/or credit scores are also pulled by service providers, like insurers and cell phone companies, landlords, and even employers — meaning, subsequently, that information can affect the price you pay for a service, the ability to rent a home or even secure certain jobs.

Basically, credit permeates all aspects of your life, so it’s important to know where you stand. Luckily, federal law entitles you to one free credit report from each major consumer credit reporting agencies a year. You can request these reports at AnnualCreditReport.com, and you can also view two of your free credit scores on Credit.com.

What Is a Good Credit Score?

The answer to this question is a little complex since there are many different credit scores out there. Most scoring models, however, utilize a range between 300 and 850. The higher your score, the better, but you don’t need to be perfect to have good credit. Scores between 700 and 749 are generally considered good, while scores of 750 or higher are considered excellent. You can learn more about what counts as a good credit score here.  

This story has been updated. It originally ran on August 21, 2014.