What is credit?

Credit has various meanings. However, credit generally refers to your ability to purchase goods or services now and pay them at a later date, usually with interest or fees.

So, if you don’t have enough money for an emergency or for something important, you can pay for it with credit. The most common example of credit is using a credit card. The issuing bank extends credit to you, and you can pay for it on the due date scheduled by the bank.

The other definition of credit is related to your financial reputation. In other words, credit also refers to your creditworthiness or credit history, which basically summarizes how well you handle your money and debts.

Common Types of Consumer Credit

There are various types of consumer credit, but they can be divided into two main categories: installment credit and revolving credit.

Installment Credit

Installment credit is a type of loan in which a borrower is given a lump sum and they’re expected to repay it in predetermined equal payments or installments over a specified amount of time. The account is closed once installment credit is paid in full.

The most common examples of installment credit are student loans, car loans, and mortgages.

Revolving Credit

Revolving credit is an agreement that allows a borrower to borrow money repeatedly up to the credit limit set by the lender. The borrower can set how much money they want to borrow and make minimum payments each month. Credit cards are the most common example of revolving credit.

Consumer credit provides plenty of advantages to a borrower. For example, having a good payment history for consumer credit accounts is essential for establishing and boosting credit scores. A borrower can also enjoy other kinds of benefits if they have a high credit score, such as faster loan approval and lower interest rates.

Creditworthiness

Creditworthiness is used to check whether you’re suitable to receive credit. In the financial world, creditworthiness is creditors’ way of checking how you handle your financial obligations. In other words, creditworthiness is proof of your ability to repay debts on time. If companies see that you are creditworthy or have an excellent credit rating, then you have a higher chance of getting your loan approved.

Creditworthiness also determines how much credit and interest rate you’re going to get. So, if you want to qualify for a mortgage or get the best credit cards, you must convince lending institutions that you’re creditworthy

There are different ways to determine creditworthiness, but the two most important ones are credit scores and credit reports.

CREDIT SCORES

When you borrow money from lenders, they usually assess your capacity to repay debts using credit scores. Landlords and insurance providers also check your credit scores when renting an apartment or applying for a policy. Some employers also assess potential hires based on their credit scores.

In general, credit scores are three-digit numbers that range from 300 to 850, and these numbers rate a borrower’s creditworthiness. A high credit score improves a person's creditworthiness, making him or her more likely to be approved for a loan.

There are three main factors that affect your credit score. They’re usually called the three C’s of credit – capacity, character, and capital.

Capacity

Capacity is about your ability to repay debt. The creditor will check if you have a steady source of income that allows you to repay your debt obligation.

Character

Based on your credit history, the creditor determines your honesty and reliability in repaying your debts.

Capital

This refers to the borrower’s valuable assets that can be used as collateral for debt obligations. When obtaining a loan, the borrower must show that they have enough savings, investments, real estate, or personal properties that can be used to repay debts in case money isn’t available.

How Credit Scores Are Calculated

Various scoring models are used to calculate credit scores, but the majority of lenders employ Vantage Score and FICO Scores.

Vantage Score was developed by the three biggest credit bureaus, TransUnion, Equifax, and Experian. According to their website, Vantage Score considers the following criteria in assessing your credit score:

1. Payment history

2. Percentage of credit limit used

3. Balances

4. Age and Type of Credit

5. Recent Credit

6. Available Credit.

FICO Scores, on the other hand, was introduced by the Fair Isaac Corporation in 1989. This credit scoring model assesses your credit score based on five factors:

1. Payment history

2. Amounts owed

3. Length of credit history

4. New credit

5. Credit mix

Although the two credit scoring models use similar basic criteria, lenders usually don’t have the same standards for approving applicants based on their credit scores.

Credit Reports

Credit reports contain a summary of your personal credit history. Credit bureaus, such as Equifax, Experian, and TransUnion, collect information about a borrower’s financial information, such as bill payment history, loans, and other credit activities. Credit reports also include the borrower’s personal information, credit accounts, and public records such as bankruptcies and foreclosures. However, other types of information, such as ethnicity and religion, aren’t included in credit reports

Credit reports play a crucial role in calculating a borrower’s credit score and identifying their creditworthiness. In other words, credit reports are used as a basis for credit scores, which lenders employ when approving or denying a loan application.

Checking credit reports regularly is essential to make sure that every piece of information in the report is correct and positive because these records influence many aspects of your life.

Monitoring credit reports at least once a year is also helpful when making an effort to repair credit. It can also help a borrower spot any errors or suspicious activities such as identity theft.

Credit is important not only in the financial world but also in other personal aspects of your life. Building a good credit reputation makes your life easier, and you can enjoy major advantages such as faster loan approval and an easier time renting or buying your own home.

In short, being financially responsible can help you build positive credit gradually and achieve financial goals without difficulties.

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