What Is Credit?

What Is Credit? - YouTube

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Having good credit makes it easier to do many things, including rent an apartment or buy a home or car; sign up for a cell phone plan; or get a student loan. With good credit, you can even save money in the form of lower scores or interest rates or waived fees and down payments when setting up utilities. Credit comes in many forms. 

In this article, we’ll break down what credit is, the types, and how you can build up your credit to unlock its many benefits.

Table of Contents

    What Is Credit?

    The word “credit” has many meanings in the financial world, it mostly refers to a contractual agreement where a borrower receives a sum of money or something else of value and commits to repaying the lender at a later date, typically with interest rates. 

    Credit can also refer to the creditworthiness from the good length of credit history of an individual or a company as in “she has good credit.” In the world of accounting, it refers to a specific type of bookkeeping entry. 

    Key Takeaways

    • Credit is a financial agreement between the lender and borrower regarding funds for a project at a certain interest rate to be repaid within a certain duration by the borrower.
    • Major credit bureaus use it to measure a borrower’s creditworthiness, which helps the lender decide whether to approve a loan or not to a borrower.
    • The credit bureau uses loan rating models like FICO to generate a three-digit number between 300 and 800, where 740-799 is the best score to avail of loans easily.
    • There are three types of loans – open, revolving, and installments. All three loans are important for – borrowers in getting loans, rented premises, and student loans, and lenders and landlords use them to secure their loans.

    Credit Explained

    Credit represents an agreement between a creditor (lender) and a borrower (debtor). The debtor promises to repay the debt owed to the lender, often with interest, or risk financial or legal penalties. The borrower must repay the debt or loan creditors lent at an agreed interest rate at a specified time. 

    On a company’s/firm’s balance sheet its entry either decreases assets or increases liability. If a borrower repays all his loans in time and closes the loan account, he has good creditworthiness or a high credit rating. However, if borrowers’ default on loan repayment, they have to risk financial or legal penalties. Also, their creditworthiness dips or credit rating decreases for every future loan. 

    The ability to repay loans builds a borrower’s credit payment history positively, or his creditworthiness increases. However, if the borrower has bad records for repayment and payment history of the loan or does not pay his loan on time, then he has bad credit, or his creditworthiness is low. 

    Credit rating agencies like Equifax, Experian, or TransUnion use a borrower’s creditworthiness to rate the borrowers’ credit power. All these rating agencies collect the relevant information from the lenders and credit card issuing agencies and then provide the information to the prospective lender or employee, or landlord for their purpose.

    The bureaus provide the loan information in the form of credit ratings with all the details of the past loan, repayment history, loan amounts and limits, installments, default in repayment if any, and inquiries for new loans in the past two years. There are different forms of credit. Some examples include car loans, mortgages, personal loans, etc. 

    However, when the bank or other financial institution makes a loan, i.e., it “credits” money to the borrower, who must pay it back at a future date. Credit cards are the prominent example of credit today that allows consumers to purchase just about anything on credit.

    The credit card-issuing bank serves as a broker between buyer and seller, paying the seller in full while extending credit to the buyer, who may repay the debt over time while incurring interest charges until it is fully paid off.

    Other Definitions of Credit

    “Credit” can also be used as shorthand to describe the financial soundness of businesses or individuals. Someone who has a good credit is considered less of a risk to lenders, than someone with bad or poor credit. Credit scores are one way that individuals are classified in terms of risk, not only by prospective lenders but also by insurance companies, and in some cases, landlords and employers. 

    For example, the commonly used FICO score ranges from 300 to 850. Anyone with higher scores of 800 or higher is considered to have exceptional credit, 740 to 799 represents very good credit, 670 to 739 is good credit, 580 to 669 is fair, and a score of 579 or lower is poor.

    Companies judged by credit rating agencies like Moody’s, Standard and Poor’s, are given letter grade scores, representing the agency’s assessment of their financial strength. Those scores are closely watched by bond investors and can affect how much interest companies will have to offer in order to borrow money. 

    Similarly, government securities are graded based on whether the issuing government is considered to have solid credit. U.S. Treasuries, for example, are backed by “full faith and credit of the United States.” In the world of accounting, “credit” has a more specialized meaning. It refers to a bookkeeping entry that records a decrease in assets or an increase in liabilities (as opposed to a debit, which does the opposite). 

    For example, suppose that a retailer buys merchandise on credit. After the purchase, the company’s inventory account increases by the amount of the purchase (via a debit), adding an asset to the company’s balance sheet. However, its accounts payable field also increases by the amount of the purchase (via a credit), adding a liability.

    Credit Ratings

    After the companies provide and prepare the loan ratings, the lenders use them to generate credit scores using the credit score model of either FICO or Vantage Score. They use it to generate a three-digit number ranging from 300 to 850. The scores segregate the customer’s creditworthiness as good, very good, and excellent. 

    Anyone can get their credit score and free credit report free cost from credit karma. Any credit score between 580-669 is taken as good. A score between 670-739 is considered very good, and a score between 740-799 is considered excellent. 

    Furthermore, the lending institutions refer to each borrower’s credit scores and decide upon the sanctioning of loans as per their internal policy. Moreover, lenders consider borrowers between the score of 740-799 to be the most trustworthy to get any loan when the person applies. 

    Your credit scores and credit report are pretty much the same thing, right? Far from it. Although a fair number of consumers conflate the two, credit score and credit report have different information that is used for different purposes.

    KEY TAKEAWAYS

    • A credit report is a detailed look at your finances, assembled all in one place.
    • The credit report contains detailed data on your financial history, assembled in four categories: identifying information, credit accounts, credit inquiries, and public records.
    • Credit scores are a numerical rating that rates your credit report in the same way that a teacher grades a student’s educational performance.
    • Credit reports are used by lenders as a shortcut to decide whether or not to grant you credit.

    Note: Universal credit is a social security payment scheme for the weak in the United Kingdom. Credit Agricole is not a loan rating agency but a project financing bank in France.

    Types Of Credit

    How Different Types of Credit Can Boost Your Credit Score

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    Credit is a written agreement between lender and borrower containing terms and conditions and a schedule of repayment of loans as per the duration agreed upon by both parties. Hence, it’s payment takes many forms like housing, vehicle, credit cards, student, and personal. 

    However, one can club and divide all the different forms of loans into three main loan types: installment loans, open loans, and revolving loans. These three have different structures and repayment schedules for the borrowers.

    Installment-Based Loan 

    This type of loan is a loan agreement between the borrower and the lender where the borrower gets the total loan amount in one time which has to be paid in equal monthly payments or installments for a scheduled time as per the agreement. It has two parts: the principal amount and the interest amount that decreases as one repays the loan. 

    After the borrower completely pays the loan on a monthly payments system, the loan is considered closed. Best examples of installment credit loans are mortgage loans, housing loans, auto loans, personal loans, and education or student loans.

    Open Loan 

    It is mainly related to gas, cable, mobile & telephony services, and electricity bills. An open loan means the consumers of the utility companies services have to pay the bill in full every month by borrowing money in the maximum limit for the said period. One example would be the post-paid mobile bill with a monthly maximum limit of borrowing, and after the end of every month, the user of the services has to pay back the bill in full.

    Revolving Loan

    This type of loan gives a maximum limit loan for borrowings or spending beyond which one has to pay certain fees and is not allowed to spend above that limit.  For individuals and businesses, credit cards and lines of credit work on the same principles. 

    For this type of loan, the borrower can spend up to the limit and then repay a small portion of the loan amount, replenish the loan account with the same amount and then borrow money again in a revolving manner. The revolving loan is either unsecured or secured with collateral. Every month, the outstanding interest on the balance has to be paid by the borrower. Home equity line of credit (HELOC) comes under this type of loan.

    What Is a Letter of Credit?

    A letter of credit is mostly used in international trade. this letter from the bank, that guarantees that a seller will receive the full amount that is due from a buyer by a certain agreed upon date. If the buyer fails to do so, the bank is answerable for the money.

    What Is a Credit Limit?

    A credit limit represents the maximum amount of credit that a lender will extend. Once the borrower reaches the limit, they will be unable to make further purchases until they repay some portion of their balance. The term is also used in connection with lines of credit and buy now, pay later loans.

    What Is a Line of Credit?

    A line of credit refers to a loan the bank and other financial institutions give. Which makes available an amount of credit to the borrower to borrow money as needed than taking it all at once. One example of this type of loan is the home equity line of credit (HELOC), which allows owners to borrow money against the value of their home for renovations or other purposes.

    What Is Revolving Credit?

    Revolving credit involves a loan with no fixed end date, a credit card account being a good example. Provided that the credit card accounts are in good standing, the borrower can continue to borrow money against them, up to whatever credit limit has been established.

    As the borrower makes payments toward the balance, the account is replenished. Revolving credit loans are often referred to as open-end credit. Mortgages and car loans, by contrast, are considered closed-end credit because they come to an end on a certain date.

    How to build your credit

    Whether you’re starting from scratch or want to build stronger credit, here are a few strategies to get you going.

    If you don’t have credit but are looking to build it

    • Become an authorized user on the account of a trusted family member or spouse who has a long, responsible credit history. By having your name attached to their line of credit, you can reap the benefits without worrying about the responsibility of payment.
    • If you can’t get a credit card because you have limited, bad credit or poor credit, try a secured card. These cards require an upfront cash deposit, and lenders can take that deposit back if you don’t pay the balance in a timely manner. After you’ve established a history of paying on time, you can look into upgrading to an unsecured card.
    • Try a credit-builder loan, where lenders (frequently community banks and credit unions, in this case) hold the money you pay in an account until the full amount is repaid, then release it back to you.
    • If you have credit but want to strengthen your score, be sure to make payments on time. Make at least the minimum payments to avoid being hit with a penalty for a missed payment.
    • Keep your credit utilization low (under 30% is good but less than 10% is ideal).
    • Keep credit accounts open, especially your most long-standing accounts. Your credit history considers your average account age, so it’s a good idea to keep your first credit card open (even if you don’t use it much now).
    • Don’t apply for too many lines of credit at once. 

    Wrapping it Up

    The word “credit” has multiple meanings in personal and business finance. Most often it refers to the ability to buy a good or service and pay for it at some future point. Credit may be arranged directly between a buyer and seller or with the assistance of an intermediary, such as a bank or other financial institution. Credit serves a vital purpose in making the world of commerce run smoothly.