All About Credit

what is credit and how does it work

We use credit to purchase items and reserve accommodations like hotel rooms and airline tickets. Credit allows us to buy NOW with the agreement to pay back our purchase over a period of time.

Credit is used to purchase homes, services, automobiles, trade goods, and more. Your credit standing is also used to qualify you for rent and in many cases, employment. Credit types include loans, lines of credit and credit cards.

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What is Credit

Credit Allows You to "Buy Now, Pay Later"

We use "credit" to buy things now with an agreement to repay the "credit" over a period of time.

For example, the car you need may cost $34,000. Instead of waiting to save enough money to purchase the car with cash, you will use "credit" to finance the purchase. You will then sign an agreement to repay the "credit" over a period of years (months).

try our credit financing calculators to run the numbers


Credit Cards Are The Most Common Forms of Credit

Other credit plans include home mortgages, auto loans, student loans, small business loans, trade financing, etc.

Credit is an important component in everyday life. You will use credit to reserve hotels, rent a car, book an airline ticket, get a home mortgage, and in some cases, apply for a job.


Maintaining a Strong Credit Rating is Very Important

Businesses will review your credit history when they evaluate your request for loans, credit cards, insurance, employment, and even leases. They may choose to grant or deny your request based on your credit history provided that you receive fair and equal treatment.

Your credit rating is based on your credit history, the amount of credit borrowing amount you have outstanding, and other factors. The higher your credit rating (or score), the more likely you will be approved for credit.


What Is A Credit History?

Credit history is a record of all of your credit cards, loans, and other credit obligations that you have assumed over a period of time.

It shows how much you have borrowed (or the amount of your credit limit), the number of payments made, and whether you have met the obligations of the repayment terms (in other words, did you make timely payments).

Credit histories are maintained by credit bureaus that lenders use when evaluating applications for credit. We have more information about credit bureaus.

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What Is The Cost of Credit?

Credit Comes With a Price: Interest Rate Charges

Banks and other lenders are willing to give you credit in exchange for interest rate charges on the "credit amount" that you borrow.

For example: let's say you need to borrow $1,000. The lender agrees to give you credit for $1,000 under an agreement that you will repay the borrowed amount in full after one year at an annual interest rate charge of 10%.

At the end of the year, you will need to repay the debt of $1,000 and interest rate charges of $100 for the use of the money. Your total repayment will be: $1,100.


Most Credit Plans Use Repayment Terms of 3, 5, and Even 10 Years or More

Home mortgage repayment plans can be as high as 30 years or more.

Lenders will use "amortization schedules" when setting up credit repayment plans. The "amortization schedule" calculates how much each month you will need to pay in order to reduce your borrowed amount with interest charges to zero over the repayment term of the loan.

You can use our sample calculators to estimate monthly repayment amounts.

You can also download FREE this amortization schedule worksheet to calculate and analyze loan repayment plans: click here

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Applying for Credit

Lenders (or creditors) generally make an evaluation on your "application for credit" using three criteria known as the "three Cs":

  • Character:
  • Capacity:
  • Collateral:


Using the "Three Cs"

Creditors will ofter merge the "Three Cs" into sophisticated computerized models to help them determine whether to grant or deny you credit.

A credit scoring system awards points for each factor that predicts who is most likely to repay a debt. Using statistical programs, creditors compare your information to the credit performance of consumers with similar profiles.

A total number of points — a credit score — helps predict how credit worthy you are, that is, how likely it is that you will repay a loan and make the payments when due.

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Tell Me More About Credit Scoring

The Credit Score is a Numeric Scoring System

Lenders use the score to speed up the loan process and provide an unbiased assessment of your loan application.

Although lenders and credit agencies have their own proprietary scoring systems, the most common scoring model used among lenders and agencies for consistency is the Fair Issac Company (FICO) model.

You can find more information about the Fair Issac Company.


FICO Will Grade Your Risk By Analyzing the Following Credit Factors:

  • Your Payment History:
    analyzes your payment of debts, whether they are delinquent or late
  • Your Amount of Outstanding Debt:
    considers the number of balances recently reported, the average balance among all credit lines or loans, and the relationship between the total balance and total credit limit.
  • Your Credit History:
    looks at the history of your accounts, the total number of "inquiries" made and new accounts opened over a period of time
  • The Types of Credit:
    looks at the type of credit you use such as mortgage loans, personal loans, credit cards, retail cards, travel cards, etc.
  • Negative Information:
    looks for bankruptcies, delinquencies or late payments, collections, too many credit lines charged to the maximum limit.

    These credit factors are compiled into sophisticated models that have analyzed credit behavior over the years. It generates a score, which in theory states that, the higher the credit score the less likely the lender is at risk that you will default on a loan.


Every Lender Has a Different Credit Tolerance Level.

One lender may reject your application because of a score while another lender approves it. Your score may be too low for one lending product but passes another.

Basically, the score lets the lender know how to treat your application. If your score falls below their minimum threshold, they may require additional information in order to make an approval decision. Again, score determination varies by lender.

For a range of FICO credit scores, see credit score


Let Us Emphasize One More Time:

It is extremely important to build a strong credit history over time. A strong credit history will give you favorable interest rates for home mortgages, consumer loans, consumer credit, business credit, and insurance.

And it is becoming more in use with employment. Many employers are using credit history as part of the application.

More information about credit scoring:

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Types of Credit

The most common type of "consumer-related" credit include the following. There is also business credit that will be not be addressed here:

Credit Cards:

The most common type of credit is the credit card. There are three types of cards:

  1. Bank Cards:
    such as VISA, MasterCard, and Discover cards. These cards allow you to purchase from 3rd party establishments with the bank ensuring payment for the purchase.
  2. Retail Charge Cards:
    such as Sears, JC Pennies, Exxon Gas, etc. These cards allow you to purchase items from the company that is issuing the card.
  3. Travel and Entertainment Cards:
    such as American Express, Diners Club, and Carte Blanche.


Debit Cards:

A plastic card that allows you to purchase items on debit — meaning that your purchases are automatically deducted from your savings or money account:

  1. Debit Cards:
    such as ATM cards that are part of the Novus®, Cirrus®, or other money networks. Purchases are automatically deducted from your account at the point-of-purchase.
  2. Check Cards:
    ATM cards that are part of the VISA® or MasterCard® network. Purchases are deducted from your accounts over a 1-3 day period.
  3. Pre-Paid Cards:
    stored value cards that are part of the VISA® or MasterCard® network. Consumers will load money to the card and use it like a credit card to make purchases.


Open Lines of Credit Plans:

An open line account allows repeated transactions up to the maximum credit limit.

You will pay a calculated amount (or some other amount greater than the minimum amount required) each month until the borrowed amount is repaid.

You can borrow an amount over again up to your available credit line limit.

Examples include credit cards, home equity lines of credit, and other open line accounts.


Closed Line of Credit Plans:

Commonly known as installment or personal loans. These plans will lend money at a fixed amount at the point of application and approval.

You will repay the amount with fixed monthly payments over a period of time.

Examples include auto loans, mortgage loans, and other fixed term loans.


Secured Loans:

Loans that require collateral that can be used to payoff the loan in the event the applicant fails to meet the debt obligations.

Mortgages, home equity, and auto loans are good examples of secured loans.


Unsecured Loans:

Loans that do not require collateral. These loans are made based on your credit score and ability to repay.

Examples include credit cards and unsecured credit lines and loans.

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