Simply put, a credit rating refers to the trust that allows one party to lend money or resources to another party with the agreement of repayment at a later date.
Lenders, property owners and service providers grant you credit based on your reputation as a borrower. If you have good credit, then that means you have established a history of borrowing money and paying it back on time. This can give you access to better loans and credit cards that are needed for significant purchases.
While credit is a powerful wealth-building tool, many people don’t understand how it works and how to use it correctly. Unfortunately, this can trap them in a cycle of debt and rising interest rates. To avoid falling into this cycle, it helps to learn how you can use credit to meet your financial goals.
Read on for the following:
How Does Credit Work?
Credit is usually something you apply for. Lenders want to make sure you can pay back what your owe before they agree to approve you for a loan, credit card or even an apartment.
Borrowing money isn’t free, however. Aside from paying back the money you owe, you also have to pay interest rates. An interest rate is a price the lender charges for the use of its money. You can think of interest rates as the reward investors get for the risk they take when they invest their money in a business or individual. The greater the risk of losing money due to someone’s failure to pay back, the less likely they are to approve someone for credit. If they do, they can do so at a higher-interest rate.
How do lenders determine your credit risk and creditworthiness? Well, they do so by looking at your credit reports, which contain information about your history of managing and repaying debt. If you typically stick to your credit agreements and make your payments on time (or early) you’ll likely be considered “worthy” of borrowing.
All of your information in your credit reports is calculated and summarized in a three-digit number called your credit score. They are calculated using the information in your credit reports that includes:
- your payment history
- how much of your available credit limit you’ve used
- the length of your credit history
- the number of times you apply for credit
- your ability to manage different kinds of credit.
If you have good credit, then you can have a better chance of qualifying for any of the following types of credit:
The Four Types of Credit
Credit can be divided into four main categories. Let’s look at them here:
Revolving credit allows you to repeatedly borrow money up to a certain amount without having to take out a loan. Minimum monthly payments are required to keep the account current, but the entire balance doesn’t have to be paid off by a certain date. The most familiar type of revolving credit are credit cards, however, personal lines of credit and home equity lines of credit also fall into this category.
Access to this type of credit is convenient and the funds are not typically restricted to a certain purchase, such as when you take out a mortgage for a home or a car loan.
Charge cards aren’t as common as they used to be, most people appreciate the freedom afforded by a credit card. Charge cards are issued by large retailers for exclusive use in their stores. Unlike a credit card, the balance might have to be paid in full each month.
Service credit is a type of credit you’re probably using without realizing it. When you sign a contract with service providers like utility companies, internet providers, gyms, cell phone companies, etc., they offer you their services and you agree to pay for them after the fact.
With service credit, you are typically expected to pay the preceding month’s bill in full each month — this is why service providers may monitor your credit score before beginning a contract with you.
Installment credit is a loan for a fixed amount of money that you agree to pay back in equal payments over a specified period of time. Home mortgages, student loan, and auto loans are all examples of installment type loans.
Why Do You Need Credit?
With the trouble that people can get themselves into with debt, you might wonder why you need credit. Maybe it’s better to stay away from loans altogether.
However, having a credit history comes with distinct benefits. First, credit can help you pay for big-ticket items like a house or a car that can be difficult to save for. Second, lenders aren’t the only entities interested in credit reports. As we mentioned, utility companies and other service providers might look at your creditworthiness before doing business with you.
Finally, you can actually make money off of credit card companies if you play your cards right. For example, if you take out a card with no yearly fee and pay off your balance every month, your card won’t cost you a dime. However, credit card companies commonly offer rewards for certain types of purchases, meaning you can make money off of them instead of the other way around.