What is Credit?

Credit is like trust…

When someone trusts you, they believe that you’ll do the things you promise to do. If a friend trusts you, they’ll pay for your meal at a restaurant and trust that you’ll return the favor, or they’ll lend you a book and believe that you’ll return it. Credit is trust from a lender or other company. You can borrow money or buy products and repay them later.

Credit is a person’s ability to borrow money from a lender or to pay for goods or services from a vendor at some point after receiving them. People who have credit have access to borrow money, while those without credit are limited in the amount that they can borrow.

Lenders and vendors grant credit to people based on how much they trust them to pay what they owe. Think about how you’d decide to lend money to someone you know. If you’ve known someone for years and they’re generally trustworthy, you’d probably lend them money. If an acquaintance who is generally flakey asks to borrow some cash, you’d be more hesitant.

Each bank and lender makes an assessment based on its experience working with you and your reputation. Each potential lender makes its own decision about extending credit to you.

There are three companies, the major credit bureaus, that keep track of how you interact with credit. They use that information to generate a credit report that lenders can view. Your credit report includes information about the number of loans you have and your history of making payments on your debts. Many lenders use these reports when considering whether to extend credit and how much credit to extend.

There are many different types of credit that a lender or vendor can extend to you.

Installment credit is probably the first thing that people think about when they think about loans and borrowing money.

With installment credit, you receive a set amount in a single lump sum. When you receive the money, you agree to pay it back on a set schedule, plus applicable interest and fees. Some lenders let you make larger than scheduled payments if you want to, while others charge a penalty if you pay the loan off ahead of schedule.

Common examples of installment credit include mortgages, auto loans, student loans, and personal loans.

When a lender gives you revolving credit, you have the option to borrow money at will, up to a limit set by the lender. When you borrow money, you have to make regular payments against the money you borrowed plus any applicable interest that may accrue. You can withdraw additional money from the loan if you need to, even while you continue making payments against your balance.

Possibly the best-known example of revolving credit is the credit card. You can use the card to borrow, up to your limit, and keep using it even as you make monthly payments. Personal lines of credit and home equity lines of credit are other examples of revolving credit.

Charge cards are relatively rare, but they’re a distinct class of credit from revolving credit like credit cards.

Charge cards function like revolving credit in that you can borrow money, as needed, up to a limit set by the lender. You don’t have to borrow money or make payments if you don’t need to. The major difference is that charge cards do not let you carry a balance from statement to statement. You must pay the full amount you borrow every statement period.

Service credit is the ability to pay for goods or services after receiving them. Businesses sometimes purchase and receive goods from vendors, but don’t pay for them until weeks later. Those vendors extend credit to the business by letting the company pay for products later.

People receive service credit from companies like utility companies, internet providers, and gyms. Usually, you get a bill at the end of the month for service or access that you received during the month. You get the benefit of the service before you have to pay for it.

Some service providers will make customers offer a security deposit if they have a history of missing payments or have a poor credit score, meaning they are unwilling to extend service credit to those customers.

Credit works based on the trust that a lender or vendor has in your ability and willingness to repay them. Every type of credit is different and the terms of how different companies extend credit can vary.

When a company extends credit, it usually starts with a written agreement between the company extending the credit (the creditor) and the party receiving the credit (the borrower). The document includes information, such as the amount the borrower is borrowing (or, for revolving credit, can borrow), the interest rate, the fees, and the payment schedule the borrower must follow.

Creditors make decisions about offering credit based on a few factors. One is looking at the borrower’s credit score. Credit bureaus produce reports and assign a numerical score based on borrowers’ previous interactions with credit. Good credit scores typically correspond to borrowers who repay their loans. That leads creditors to trust borrowers with good credit scores.

Creditors might also extend credit based on other factors. For example, creditors can offer loans secured by other assets to reduce their risk. Mortgages are prime examples of this. The borrower uses the money to purchase real estate, and the real estate they purchase secures the loan. If the borrower fails to make their payments, the creditor can foreclose on the home to recover the money it lost.

Even casual loans, such as friends offering to lend money to each other, are based on trust. If your friend trusts you, they might be more likely to lend you money if you ask.

A credit score is a numerical score, ranging from 300 to 850, that represents your previous interactions with credit.

Credit bureaus, such as Experian, Equifax, and TransUnion, track how you use credit, collecting information about your loans and their balances, your payment history, and your applications for new credit. They use the information they collect to compile a credit report for you and to generate a credit score.

When you apply for a loan, many lenders request a copy of your credit report from one of the bureaus. The bureau sends the report, as well as your credit score, to the lender.

Lenders often use your credit score when making a lending decision. Typically, people with better scores qualify for more loans or secure other benefits such as reduced interest rates and fees.

Credit is important for several reasons.

Access to credit makes it much easier for people to make large purchases that they couldn’t otherwise pay for with cash. Few people would be able to buy a home or a car if they weren’t able to borrow money to afford the expense.

Even smaller transactions become easier with credit. If you want to go shopping, you can use a credit card to make your purchases quickly and easily. Paying with cash involves carrying a large number of bills, and paying with a debit card generally requires keeping a good deal of money in your checking account and forgoing the protections credit cards usually carry if you have a dispute with a merchant.

The word credit comes up frequently in accounting but has a different meaning than the one that relates to trust and borrowing money.

In the world of accounting, a credit affects different aspects of a company’s financial statements, such as their general ledger, and balance sheet.

Following the accounting equation, credits increase the balance of liability accounts, such as accounts payable, reduce the balance of assets, such as cash in bank accounts, and increase the balance of equity accounts.