- Credit is a method of borrowing that enable you to buy something now and pay for it later. For example, if you make a purchase with a credit card or take out another type of line of credit, you’re required to pay that money back in the future. With almost all forms of credit, the borrower has to pay back more than they were originally lent. Generally, they do this by paying interest on the amount borrowed.
What is credit?
Credit is a type of borrowing — with most forms of credit, the borrower has to pay back the lender more than they originally borrowed. This ensures that offering credit is profitable for the lender. Generally, the cost of borrowing comes in the form of interest that the lender charges on the amount borrowed.
Credit can be extended to individuals, businesses and governments. Since the rules that govern credit can be very different for governments and businesses, this glossary page will focus primarily on personal credit.
How does credit work?
The three most common forms of credit are loans, lines of credit and open accounts. Loans involve a lump sum of money that is issued to borrow, while lines of credit involve a pre-determined credit limit that the borrower is able to borrow up to.
Open accounts are used for utilities like electricity, gas and cable. With an open account, there is a balance every month that has to be paid in full. Because the accounts have to be paid off in full and cannot be extended past the due date, there is no interest. The cost of lending is included in the amount that is charged. Charge cards also use an open account model.
A person’s ability to borrow money will often rely on their credit score, which states how likely they are to meet their credit obligations based on past behavior. Many lenders report payment (and nonpayment or late payment) to credit bureaus, which are businesses that track a person’s history of credit usage and put it all into a document called a “credit report“. Credit scores are based off of the information in a person’s credit report, so failure to repay or consistently being late on payments could cause your credit score to suffer. This would then affect the kinds of credit and interest rates that you are able to qualify for in the future.
What is interest?
Interest is an amount of money that the borrower pays the lender beyond the original amount borrowed. It is the cost the people pay for the privilege of borrowing money.
However, Interest is different from a normal flat fee. More specifically, interest is a percentage of the amount borrowed that is charged over a certain period of time. For instance, a loan could have a monthly interest rate of 1%. This means that, for every $100 that’s borrowed, the borrower owes $1 every month until the loan is repaid. Now, this interest rate could also be expressed as a 12% annual interest rate, because getting charged 1% per month for 12 months would come out to 12% per year.
When taking out a loan or line of credit, it is always a good idea to check the interest rate. However, it’s also a good idea to find out the loan’s annual percentage rate, or APR. The APR for a loan or line of credit includes not just the interest rate, but also any additional fees that the lender is charging. It will give you a better idea of the loan’s actual cost.
What is secured and unsecured credit?
Some credit is secured by collateral, which is a term for any valuable asset that the lender can claim if the borrower does not repay their loan or line of credit. Common forms of collateral are houses, real estate and motor vehicles. Many larger loans and lines of credit are secured by collateral to protect lenders against the risk that the borrower will not repay. Using collateral also allows lenders to charge lower interest rates for these loans. Credit that is backed by collateral is called “secured credit”.
There are also forms of credit that are not secured by collateral. These loans and lines of credit typically have higher interest rates as they are a bigger risk for the lender. Because the lenders cannot count on the collateral in the event of nonpayment, the lenders rely on a person’s credit score to determine whether or not they can repay the loan. Credit that is not backed by collateral is called “unsecured credit”.
How does a loan work?
With a loan, the borrower is given an amount of money that they then pay back over time plus fees and interest. The amount that they are lent is called “the principal”. Loans usually come with a specified term, or period of time, over which the loan is to be repaid. For instance, a loan with a six-month term would be paid in full within six months, whereas a loan with a 12-month term would be repaid within a year.
What is an installment loan?
An installment loan is a loan that comes with a schedule of regular payments through which the loan is repaid over a set period of time. Each payment that is made goes towards paying off both the interest and the principal. The first payments that are made go primarily towards the interest, with each payment paying more and more towards the principal. This process of paying off the interest and the principal according to set schedule us called “amortization”.
Some loans do not come with regularly scheduled payments. These loans simply have a due date, by which time the loan is to be repaid in full. Many of these loans have much shorter terms than installment loans. For instance, payday loans have an average term of just two weeks.
What is a line of credit?
With a line of credit, a person is given a maximum amount that they can borrow, called a credit limit. A borrower is not given any money up front with a line of credit, rather they receive a limit and they are permitted to borrow as much or as little as they care to up to that limit. Though they are allowed to borrow up to the limit, they are not required to.
With lines of credit, a person only has to pay back what they borrow. Plus, they are only charged fees or interest on what they borrow, not on the maximum credit limit. Unlike loans, which usually come with pre-determined repayment periods and payment amounts, lines of credit have repayment periods and payment amounts that vary depending on how much has been borrowed.
With a standard line of credit, the amount of funds available does not replenish when the borrower pays off what’s already been borrowed. For instance, if a line of credit has a $5,000 limit, and a person borrows $1,000, they would only have $4,000 left that they could borrow even if they paid that $1,000 off.
A revolving line of credit works differently. In a revolving line of credit, the borrowing limit replenishes when the borrower makes payments on what they’ve already borrowed. In the previous example, if the borrower made a $500 payment on the $1,000 that they owed, they would then have $4,500 that they could borrow against the $5,000 limit.
Most credit cards are revolving lines of credit. Home equity lines of credit are lines that are secured by the value of the borrower’s home.
What are different kinds of lenders?
Banks are the most traditional kind of lender. In addition to offering checking and savings accounts (as well as investment opportunities), banks issue many different kinds of loans, including personal loans, mortgages and auto loans. Banks are generally seen as very conservative lenders, which means that a high credit score and a regular income are needed in order to get a loan from a bank. Customers with poor credit histories are unlikely to be approved for a bank loan.
Credit unions are another kind of lender. They operate much like a bank in many ways, with a few key differences. Credit unions are non-profit, member-based institutions. Whereas banks will do business with anyone who is deemed credit-worthy, credit unions have additional criteria for membership. Membership in a credit union might depend on where you live or work, what church you attend or what civic groups you belong to.
Because credit unions are not-for-profit, they turn any profits they earn into benefits for their members. This means that a loan from a credit union will likely come with lower interest rates than a loan from a bank. Many credit unions also offer small-dollar loans that can serve as an alternative to costly payday loans. However, all of their loans are only available to members of the credit union.
There are some lenders that specialize in only one kind of loan. This is most common with mortgages and auto loans. Some of these lenders are associated with other businesses. For instance, an auto lender might work together with a car dealership to secure financing for their customers. Some of these lenders are actually brokers. This means that they arrange the loans and collect a fee, while financing is secured by a separate lending institution. Brokers are very common when it comes to mortgage loans.
There are also peer-to-peer lenders that facilitate loans between private individuals. They pair people who are looking to make an investment through lending money with people who are in need of a loan. The advantage for the investors is that they can earn more from these loans than they could from more traditional investments. The advantage for borrowers is that peer-to-peer lenders will often extend credit to borrowers who would not qualify for a loan from a traditional lender. However, due to this increased risk, peer-to-peer loans often come with higher interest rates than traditional loans.
There are some lenders, like OppLoans, that lend entirely online. It is rare for traditional lenders like banks or even credit unions to lend solely online; many of them still require that their borrowers come and visit a local branch in person. Online lending allows for increased speed and convenience in securing a loan. However, it’s a good idea to do lots of research when taking out a loan online, as there are many online lenders that are considered predatory.
What are predatory lenders?
Predatory lenders are lenders that take advantage of people in desperate circumstances. They target low-income communities where people have meager savings and not-so-great credit scores. Because these are people that have fewer options when securing a loan, predatory lenders can charge incredibly high interest rates. Oftentimes, the APRs for predatory loans can be 300% or higher.
The two most common types of predatory lenders are payday and title lenders. Payday lenders offer short-term, small-dollar loans with high interest rates that can come out to an APR of 400% or higher. Title lenders offer larger loans that use the borrower’s motor vehicle as collateral. Their average APR is 300%.
Predatory loans can trap borrowers in a cycle of debt. This happens when a person cannot afford to repay their loan on time and the lender offers to “rollover” the loan, extending the due date in return for charging additional fees and interest. When the person cannot afford to pay the additional costs of the loan, the lender offers to rollover the loan again, which means even more fees. Eventually, the person owes far more than they could ever hope to repay. In many instances, they will have their wages garnished in order to pay back what they owe.
Payday and title loans are illegal in some states, but there are many states where they are still permitted. Additionally, there are many predatory mortgage and auto lenders that offer dangerous loans to customers with low credit scores.
What is a Credit Score?
A credit score is a three digit number that measures a person’s credit-worthiness. The most common kind of credit score is a FICO score, which was created by the Fair, Isaac Company in 1989. The FICO score is so common that “credit score” and “FICO score” are often used interchangeably.
A FICO score is based on a scale from 300 to 850. The higher the score, the more credit-worthy a person is deemed. A person’s credit score is based off of the information in their credit report.
What is a Credit Report?
A credit report is a document that tracks a person’s use of credit over the past seven years. These profiles are created and compiled by the three major credit bureaus: Experian, TransUnion, and Equifax. The companies gather information from businesses like lenders, collections agencies, and landlords, as well as from the public record.
The reports contain information such as how much credit a person has taken out, what different kinds of credit they’ve used, whether or not a person paid their bills on time, whether they have any outstanding collections against them, and whether or not they have filed for bankruptcy.
By law, the credit bureaus are required to provide people with one free copy of their credit report per year upon request. To request a free copy of your credit report, visit www.annualcreditreport.com. Credit reports can and do have errors in them. If you find an error in your credit report, please read this helpful guide from the Consumer Financial Protection Bureau.
How does a FICO Credit Score work?
FICO credit scores not only include information from your credit history, but they also weigh some factors more heavily than others. The scores are weighted like so:
Payment history is 35%. Have you paid your bills on time and in full? If you haven’t, this could have a major effect on lowering your credit score.
Amounts owed are 30%. People who have a lot of debt relative to their income are going to have lower credit scores.
Length of credit history is 15%. The longer you have been responsibly using credit, the better.
Credit mix is 10%. Do you have a mix of student debt, mortgage debt and credit card debt? Or does the majority of your debt originate from one source? For instance, a heavy amount of credit card debt could be a sign of poor credit use.
New credit inquiries are 10%. Have you made other recent credit inquiries? If your record shows that you have been trying to take out a lot of different loans or credit cards in recent months, lenders might take it as a sign that your finances are in trouble.
What does my FICO credit score mean?
FICO credit scores are based on a scale between 300 and 850. The higher a person’s credit score is, the better their credit. Here are the basic ranges:
720-850 – Great Credit. People with credit scores in this range are able to score better loans that come with lower interest rates and more favorable terms. There are very few loans for which they will not qualify.
680-719 – Good Credit. People with credit scores in this range will qualify for most loans. They might have to pay slightly higher interest rates, but the terms in general are still going to be favorable.
630-679 – Fair Credit. People with credit scores in this range are definitely going to have to pay more in order to borrow and there are many larger loans that they either will not qualify for, or will be too expensive for them to afford.
550-629 – Subprime Credit. People with scores in this range have trouble getting approved for a majority of loans. When they do get approved, the loans are oftentimes going to be very expensive. People with scores in this range should be on the lookout for predatory lenders.
300-549 – Poor Credit. People with credit scores under 550 are going to have trouble securing any loans at all. The only loans they will qualify for are going to be dangerous, high-interest payday and title loans that don’t require a credit check. It is important for people with scores in this range to avoid predatory lenders and to work to improve their credit rating.
Where can I find my credit score?
It is important that you know your credit score, as it has a massive impact on your ability to borrow money. To obtain a free copy of your credit score, you can always sign up for a website such as CreditKarma.com or CreditSesame.com. These websites are free, but you will also be signing up for a lot of emails and advertisements if you join them. You can also sign up for a paid account with any of the credit bureaus or with FICO.
How can I improve my credit score?
There is only one real solution to improving your credit score, and that is by making responsible financial decisions moving forward. Paying bills on time, budgeting, making a plan to consolidate and/or pay down debt and not relying on credit to finance everyday expenses; these are all behaviors that can lead to an improved credit score. Remember, a person’s credit score only goes back seven years, which means that poor decisions from the past can fall off your credit report and be replaced by better decisions.
Unfortunately, this solution is going to take some time. There is no quick fix to improving your credit score. For this reason, you should be wary of companies that you see advertising credit repair services.
What If I have too much debt?
People who have more debt than they can afford would do well to try a credit-counseling service. These are not-for-profit companies that can help with financial and budgeting advice. They can also negotiate with a person’s creditors in order to secure lower interest rates or amounts owed.
If the creditors agree to these new terms, the credit counseling agency can execute a Debt Management Plan (DMP). This is an agreement between all parties that lays out the new terms under which the debts are to be repaid. DMPs should not negatively affect a person’s credit score.
To find a list of HUD-approved credit counseling services, check out the US Department of Housing and Urban Development’s website. Avoid credit counseling agencies that are not HUD-approved. It is also best to avoid debt settlement companies. These provide a similar service to credit counseling agencies, but they are for-profit, run a higher risk of damaging a person’s finances, and are far more likely to take advantage of their customers.
People with too much debt who have no other options can also file for bankruptcy. This is a legal procedure wherein a plan is made to settle their outstanding debts. Bankruptcies, as previously mentioned, can have a very negative affect on a person’s credit score. However, sometimes getting out from under a burden of debt is worth the hit.