- Credit is the ability to access money, goods, or services now and pay for them in the future.
- The three major credit bureaus track and analyze transactions to calculate your credit score, a 3-digit number rating your financial reputation.
- Your credit report, credit history, and credit score can impact your ability to get a loan, rent a house, finance a vehicle, or get a job.
Credit is a vital part of your financial tool belt. It allows you to make major purchases like buying a home or financing a car. It also measures your financial reputation in the eyes of creditors, retailers, and potential employers.
But what is credit, exactly? And why is it so important?
In this guide, we break credit down into simple terms. We’ll also define credit and dive into details on why it’s crucial to establish it.
What is credit?
Credit is the ability to access goods, services, or funds now and pay for them in the future. You can also think of it as your capacity to repay your debts as promised—often with additional fees.
If a lender is confident in your ability to repay your debts, you’re more likely to qualify for financing like personal loans, mortgages, or business loans. You may also get approved for a lower interest rate, since you present less of a risk to a potential lender.
Credit impacts more than your finances, too. For a closer look at how credit can influence some of the most important parts of your life, consider the following statistics:
- 70% of students who receive a Bachelor’s degree use a loan to fund a portion of their college expenses.
- 81% of new car purchases in the first quarter of 2021 were financed.
- 96% of first-time home buyers finance their homes with a mortgage.
- 56% of small businesses apply for funding to expand their operations or pursue new opportunities.
- 30% of the average American’s monthly income goes toward repaying debts other than home mortgages.
With this in mind, it’s important to establish good credit as a tool to help you achieve your personal, professional, and financial goals.
How is credit determined?
Historically, creditors based your capacity for credit on your reputation. As you can guess, this resulted in a somewhat flawed rating system that left many people without fair access to financing. However, affordable credit—and access to it—can have a substantial impact on a borrower’s quality of life.
Fortunately, modern lending companies, credit card companies, and credit bureaus take a more objective approach to credit. In most cases, complex algorithms consider factors like your borrowing habits and repayment history when determining whether you have a good or poor credit reputation.
We’ll dive into this in more detail below. In the meantime, let’s take a closer look at the importance of building good credit.
Good credit vs. poor credit
If you have a solid record of repaying your debts on time, creditors will likely say you have good credit, or that you’re creditworthy.
Creditworthiness helps lenders feel confident you’ll repay your debts, plus any fees or interest charges. It may also mean you’re more likely to qualify for access to important financing, like business loans, mortgages, or personal loans.
The opposite is also true. If you have an unreliable credit history—or no credit at all—potential lenders might say you have poor credit. Poor credit can make it harder to get approved for loans because you represent more of a risk to lenders.
How does credit work?
You build your credit over time as you borrow money and repay your lenders. The three major credit bureaus track these borrowing and repayment habits. Then, they add certain transactions to your credit report, such as new loan applications, recently opened accounts, and your existing balances.
The credit bureaus monitor these transactions and use the information to calculate your credit score, a 3-digit number that rates your financial habits and assesses your creditworthiness.
Certain people and financial institutions may be able to view your credit rating, credit history, and credit report when making decisions that impact your life, finances, or career. With that in mind, it’s critical to understand and manage your credit.
Let’s take a closer look at the three major components of credit: credit bureaus, credit reports, and credit scores. We’ll then examine how these components work together.
There are three major credit bureaus in the United States: Equifax®, Experian™, and TransUnion®. Also known as credit reporting agencies, the bureaus monitor and record financial details from your bank, loan providers, credit card issuers, and other sources of credit.
Financial institutions aren’t required to report your borrowing and repayment behavior to the credit bureaus. However, most do so voluntarily. The bureaus then track, analyze, and distribute the information as needed.
Your credit report is a document that contains a summary of your financial behavior during the last 7 years. Each bureau prioritizes different details, but some of the most common include:
- Past and current loans
- The amount and age of your credit lines
- The total amount you’ve borrowed and what you currently owe
- The minimum monthly payments on each loan or line of credit
- Your repayment history
- Credit inquiries from the last 2 years
- Debts in default or collections
- Foreclosures or tax liens on your record
Remember, your credit reports can make or break major financial decisions. Thus, you should review your credit reports annually to ensure the information is correct.
You can access a free copy of your credit report at AnnualCreditReport.com. If you find an error, you can then petition to have the transaction corrected or removed from the document.
The information on your credit report informs your credit score, or the 3-digit number that rates your financial behavior.
Each credit bureau has its own scoring methods. However, they all rely on an algorithm to calculate the score. The algorithm analyzes your credit history for patterns, red flags, and creditworthiness signals. Then, it boils the information down into a succinct, easily digestible rating.
Lenders can then use your credit score to make financial decisions. Typically, higher credit scores indicate a solid credit history. Lower scores signal an opportunity to improve your financial habits.
Types of credit
Credit is commonly divided into 4 categories, as follows:
Most modern consumers are familiar with revolving credit. It’s often issued as a credit card with a maximum credit limit. You can use as much of your credit limit as you want. But, you must repay the balance in part or in full.
If you choose to repay part of your balance, such as the minimum payments, you “revolve” the rest of the debt to the following month. In many cases, you have to pay interest fees on top of the revolving balance.
Installment credit is given in the form of a loan. It includes mortgages, personal loans, auto loans, and student loans. Typically, you receive a predetermined amount in a single lump sum payment. Then, you’ll repay the loan, plus interest, in monthly payments (or installments) over time.
Service credit comes from service providers, like your utility companies or cell phone provider. In most cases, you establish a service credit line ahead of time, use the services or utilities for a predetermined period, and then repay providers at the end of the billing cycle.
Although largely defunct, charge cards were once used in retail stores. Retailers would issue the cards to shoppers, who would then use them like credit cards. However, users weren’t allowed to carry a balance. Instead, they had to repay their charges in full each month.
What does it mean to buy something on credit?
Buying something on credit means you borrow money to purchase something with the understanding you’ll pay for it later. For instance, you can buy groceries or concert tickets with a credit card.
When you reach the end of the billing period, you can pay off the balance. Or you may decide to make payments and stretch your costs out over several months.
Remember, you’ll likely face additional interest charges if you don’t repay the balance in full by the payment deadline.
What’s the difference between debit and credit?
When you use a debit card to pay for a purchase, the funds leave your bank account almost immediately. The transaction is complete, and you don’t have any balance left to pay.
But when you use a credit card, the money comes from a previously established line of credit. You can then repay the balance at a later date.
What do you need credit for?
When it comes down to it, you need credit for a lot of things. A solid credit history is especially important if you want to borrow money to buy a house or finance a car. That’s because a good credit history—and a higher credit score—represent less risk to potential lenders.
As a result, you may be able to qualify for credit cards or loans with better interest rates and terms. However, lenders aren’t the only ones who may use your credit score when making decisions.
Your credit history, credit report, and credit score may also affect your ability to:
- Get a job: Some potential employers review your credit report during the interview process. Your potential boss may not be able to see your credit score, but they can view information related to your payment history, outstanding loans, and open lines of credit.
- Rent a house or apartment: Thin or poor credit can make it difficult to rent a house or apartment. Many landlords review your credit and repayment history to ensure you’ll be a reliable tenant.If your record shows numerous missed payments or loans in default, the landlord may opt for a tenant with fewer red flags. Or at the very least, you may get hit with a higher security deposit to mitigate the landlord’s financial risk.
- Get auto insurance: Did you know improving your credit could help you save money? Many insurance companies offer lower rates to applicants with higher credit scores. That’s because insurance companies have found payment history and total debt can accurately assess your risk level. Lower-risk drivers tend to have fewer insurance claims, while high-risk drivers file claims more often.
- Set up utilities: In some cases, utility companies run credit checks before they approve your service application. Like any service provider, utility companies want to feel confident you’ll pay them for their services after using them.If your credit report shows repeated missed or late payments, you may have to make a deposit before you can access the service. Other utility companies require you to provide a letter of guarantee from a friend or relative who promises to pay your bills if you don’t.
- Take out a personal loan: Finally, establishing a solid credit history can come in handy if you ever need a personal loan to consolidate debt or make a large purchase. Personal loans are unsecured loans, which means they aren’t backed by personal property like your home or car. As a result, they often come with slightly higher interest rates.If you have good to excellent credit, you may qualify for an affordable loan with better terms, like a lower interest rate or flexible repayment options. If your score falls below the “good” range, your interest rates may be higher, resulting in more expensive monthly payments. Unfortunately, getting a legitimate personal loan with no credit at all could be difficult.
That’s where Upstart comes in. Our model looks beyond your credit score, using non-conventional variables such as employment and education¹, to help you get the rates you deserve on personal loans, debt consolidation loans, and more. That way, you can get the money you need and potentially boost your credit by paying down existing debt and making regular monthly payments.
The importance of credit access and how to start building yours today
As you can see, credit can significantly impact your life. Credit really matters, and affordable credit has been essential to unlocking mobility and opportunity.
Building credit isn’t always easy, though. In many cases, it can feel like a vicious cycle of needing credit to establish more credit. But if you’re not sure where to start, we’ve got you covered. We offer reliable resources to help you establish credit from the ground up or build your credit for a healthier financial future.
¹Neither Upstart nor its bank partners have a minimum educational attainment requirement in order to be eligible for a loan.