What is Credit and How Does it Work?

One of the more common terms that you’ll run into when dealing with your day-to-day finances is ‘credit’. We constantly hear about people with ‘good credit’ or ‘bad credit’, we get asked about our credit score or our credit history and, all in all, it seems like a pretty big deal. But what does this all really mean? Often, banks and other money lenders just assume that you understand all of these terms and, sometimes, the experts are so preoccupied with explaining the big, complex matters that they forget to cover the basics and many of us are left wondering – What is credit? How does it affect my finances and how does it all work? What is Credit and How Does it Work?

Credit refers to your ability to borrow money from a lender thanks to an agreement or contract which states that you will pay it back at some later date (normally with some interest involved). In some instances, it can also refer to certain goods or services which are borrowed under the same premise.

In other words, a person ‘with credit’ will be able to make purchases (usually with a credit card) when they run out of money because their bank or lender trusts that they will pay it back later.

 What is Credit and How Does it Work?
What is Credit and How Does it Work?

Your individual credit (ie, the specific amount that you can borrow) is based on a number of factors such as your income, your credit score, your total debt, etc. As a result, everybody will end up having a different level of credit due to their particular circumstances.

What are some Examples of Credit?

As mentioned, credit cards are a great example of credit. Once you run out of actual money to make purchases, you can simply swipe your credit card to pay for them. In effect, the bank is paying on your behalf because they believe that you will be able to pay them back later.

Most loans can also be described as credit. When you can’t buy something outright, such as a car or a house, you can approach the bank for a loan and agree to reimburse them when you are able to.

In certain cases, credit may also refer to goods and services that are borrowed rather than money. For example, a food supplier could give a baker the ingredients needed to create their pastries in the knowledge that the baker will pay for the ingredients once the pastries have been sold. Alternatively, a foreman may hire workers and promise to pay them once the job has been completed and payment has been secured.

 What is Credit and How Does it Work?
What is Credit and How Does it Work?

What is Credit Used For?

Credit is an exceptionally useful thing to have when you desperately need to make a purchase that you simply don’t have enough money to afford. Because banks normally have more money than you, they can lend you what you need and allow you to pay it back with interest over time.

Sometimes, people use this service to pay for things that would otherwise be impossible to afford in the meantime, such as property, vehicles, university fees, etc. Such individuals are essentially accepting the added cost from the interest rates because it’s worthwhile in the long run.

Other times, people may just be going through a rough patch where they can’t afford to pay for something that they currently need and using credit is the only way out, for example, when a loved one dies and they need to cover the funeral expenses.

Why do you Need Credit?

Credit is necessary for most of us simply because the cost of things usually outpaces our income. If you happen to be extremely rich, perhaps you can go through life without credit and just pay for things with the money you have in your bank account. For the rest of us though, we will frequently encounter periods in life where we just aren’t earning enough cash to purchase everything we need. When this occurs, we need credit to carry on.

What is a Credit Score?

Moneylenders don’t just give out cash to anybody who asks for it. Before you get a loan, they like to ensure that you’ll actually be able to pay it back and that you’re likely to do it on time. But how do they figure something like that out? Well, this is where your credit score comes in.

Your Credit Score is a three-digit number that money lenders use to determine your creditworthiness. Credit Bureaus determine this number by considering a wide array of factors such as your total debt, your income, your repayment history, etc.

A creditworthy person will receive certain benefits that will not be extended to those who are seen as unreliable.

Simply put, a person with a high credit score probably has a stable income, a relatively low level of debt, and a history of paying their debts on time. Such an individual will be seen more favourably by lenders which will increase his/her chances of being approved for a loan. Additionally, this person is more likely to receive their loan at a lower interest rate and will probably be able to borrow more money overall.

 What is Credit and How Does it Work?
What is Credit and How Does it Work?

By contrast, someone with a low credit score probably has a lot of debt relative to their income and a history of not paying it back on time. This type of person will find that it is much harder to get a loan and will probably only be approved after accepting a higher interest rate.

At the end of the day, it’s always better to have a high credit score, but this raises another question – What do we even mean when we talk about a ‘higher credit score’?

What is a Good Credit Score?

Different credit bureaus have different maximum limits when it comes to credit scores, so it’s good to double-check what your specific score means with them. That said, by comparing the numbers from Experian and Transunion we can work out what each score means, broadly speaking –

Credit ScoreAverage Rating  
Below 600  Poor/Very Poor
What is Credit and How Does it Work?

As you can see, you want a credit score of at least 650. This may seem challenging, especially if your current score is nowhere near that number, but don’t panic, there are multiple ways in which you can go about improving your rating.

How Do I Improve my Credit Score?

There are a couple of different ways to up your credit score, they include, but are not limited to, the following methods –

  • Pay your outstanding debts as soon as possible
  • Pay the rest of your debts on time
  • Avoid opening new credit accounts
  • Try to maintain a low credit utilization rate

In Conclusion – What is Credit? (Simply Explained)

Credit just refers to your ability to borrow money from a lender under an agreement that states that you will pay it back at a later date (usually with interest). In other words, credit allows you to pay for things when you have run out of money and then pay that money back when you are able to. Perhaps the most common example of credit is seen in the use of credit cards, which allow the user to keep making purchases even after they have used up all of their cash.

 What is Credit and How Does it Work?
What is Credit and How Does it Work?

Credit can also apply to certain goods and services when they are obtained under a contract that states that repayment will occur at a later date. For example, a farmer may borrow seeds or equipment after agreeing that he/she will pay for them once they make money from their harvest.

Credit is oftentimes a necessary part of life as most of us cannot always pay for everything we need with the money that is available. Loans used to pay for vehicles and property can also be seen as a kind of credit and are usually unavoidable for most people.

Perhaps the biggest factor when receiving credit is your individual credit score. This score is represented as a three-digit number that is used by lenders to determine your creditworthiness. A higher credit score will allow you to take out more money at a lower interest rate which means that you will be paying back less in the long run. Credit score can be increased in many different ways such as by paying debts on time and lowering your credit utilization rate. Different credit bureaus have different credit rating systems so it’s important to check in with them to determine exactly where you stand.

Disclaimer Finance101: All of our posts are for research purposes only. Finance 101 aims to assist its readers with useful information on the laws of our country that can guide you to make financial decisions that will enable you to become more financially independent in the future. Although our posts cite the constitution in many instances, they are intended to assist readers who are looking to expand their knowledge of the law & finance related queries. Should you require specific legal/financial advice we advise you to get in touch with a qualified financial expert.

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