What You Need to Know About Credit and How It Works
Credit seems simple: you can open a credit card account while at a store, be approved in minutes, and then get 10 percent off your purchase. Convenient, easy, and you saved a few bucks. Great!
But what that frictionless transaction brushes to the side is that how you use credit — when and how you acquire it, how promptly you pay it back — establishes a credit history that has an impact on many areas of your life.
Understanding how credit works will provide you with knowledge you need for the important financial decisions you will make throughout your lifetime. So let's take a closer look...
What is Credit?
In its simplest terms, credit is the ability to borrow money or access goods or services with the understanding that you will pay later.
Lenders, merchants, and service providers (known collectively as creditors) grant credit based on their confidence that you have the ability and willingness to pay back what you borrow, along with any interest that may apply, which is what creditors charge to give you access to the credit. To the extent that creditors consider you worthy of their trust, you are said to be "creditworthy."
What Types of Credit Exist?
There are two main types of credit: revolving, and installment. In each scenario, credit is borrowed, but repaid with a different structure. And each affects your credit score in different ways.
- Revolving credit accounts allow you to repeatedly borrow and repay amounts from a single line of credit, and a credit limit is set — a maximum amount you can spend on that account. In most instances, you can choose either to pay the balance in full at the end of each billing cycle or you can carry a balance from one month to the next, or "revolve" the balance. Most credit cards count as revolving credit as there is a capped limit (the credit card limit), and you can keep using it until you reach such a limit (then over-limit fees apply). Another example would be a HELOC (Home Equity Line of Credit).
- Installment credit is simply a type of loan in which you borrow one lump sum and repay it in regular fixed payments, or "installments" over a set amount of time. The loan will have an interest rate, repayment terms and fees, which will affect how much you pay per month. Common types of installment loans include mortgages, car loans and personal loans.
| Revolving Credit | Installment Credit |
|---|---|
| A line of credit with a defined limit | A lump sum loan |
| Can pay in full at the end of each billing cycle, or carry ("revolve") part of the balance | Repaid in regular, fixed payments, or "installments" |
| Typical uses: credit cards, home equity line of credit (HELOC), business line of credit | Typical uses: mortgage, personal loans, business loans |
Secured vs. Unsecured Credit/Debt — What's the Difference?
Lines of credit can be secured or unsecured, and there are significant differences between the two, such as the interest rate paid by the borrower.
- "Secured" credit refers to credit tied to an asset that belongs to the borrower, such as with a mortgage (in which case the asset is the house). The asset becomes collateral and can be seized or liquidated by the lender if you fail to pay. Since the bank has more certainty of getting its money back, secured credit typically comes with higher credit limits and lower interest rates vs unsecured credit.
- "Unsecured" credit refers to credit that is not tied to a specific asset. The borrower's assets are not subject to seizure if they default on the loan, and therefore the lender is assuming greater risk in granting this unsecured line of credit. Most credit cards are unsecured lines of credit, which is one reason why their interest rates are so high: if the cardholder defaults, the credit card issuer has nothing it can seize for compensation.
| Secured Credit | Unsecured Credit |
|---|---|
| Guaranteed by collateral | Not guaranteed by an asset |
| Lower interest rates than for unsecured credit | Riskier for lenders, so interest rates are higher |
| If a borrower defaults, lender can seize collateral | More difficult to get approved by lenders |
Whether you choose a secured or unsecured line of credit depends in large part on why you are using it. If you need to borrow a lot of money — for a home renovation, for example, or seeding a new business — an unsecured line of credit is usually not the best option, as it can be prohibitively expensive due to high interest rates. A bank loan, whether in the form of a business loan or a mortgage or a home equity line of credit (HELOC) is likely your best bet, assuming you have a high enough credit score to get a loan at a favorable rate. (Read more about your credit score and what impacts it.)
Do I Have to Have a Great Credit Score to Qualify for Credit?
Great credit score, not necessarily. Good credit score? Almost definitely if you are applying for any kind of credit, and definitely if you are applying for a loan.
Loan applications will gather personal information including income, time in your home, and job history to get an overall picture of your stability. Today, many lenders use automated systems that conditionally approve or deny based on a few key factors, including your credit score — and this means most denials of credit or loans are not ever reviewed by a human, even if your qualification is just under the lender's threshold.
Credit scores are also used to determine what terms and rates you will be offered. The higher your score, the more preferential (and lower) the rate you can acquire. Those with high credit scores will also be offered higher credit limits on credit cards.
Is There Such a Thing as Having Too Much Credit?
The amount of credit you qualify for will always be based on your income and your credit score; the higher your income or credit score, the more credit you qualify for, if you have maintained sterling on-time payments for your loans and credit cards. Having available credit lines means you have financial flexibility, and can react when an unplanned event happens in your life, whether that's replacing your home's boiler when it suddenly goes kaput or being able to make large purchases that you pay for across many months. So on one hand, no, you can't have too much credit — if you don't max out your credit limits.
The better way to phrase this question is this: can you have too much debt? Yes, of course. For some people, having available credit proves to be a difficult temptation to resist, and can encourage overspending. So take only the credit you need and for a specific timeline. And in the case of credit cards, your best bet is to pay them off in full, every month.