Understanding Credit

Learn more about credit and how it can impact all of your financial life.

Credit is more than just a plastic card you use to buy things. It represents your financial trustworthiness. Your credit history can follow you for many years. So if you want to make a purchase using credit, it's important to understand how credit works.

What Is Credit And What Types Are Available?

Credit is simply the promise to pay for something over time instead of paying the full price in cash up front when making a purchase. Credit can come in the form of a credit card or a loan. Both credit cards and loans come with terms for repayment that specify when payment is to be made, what interest rate or Annual Percentage Rate will be associated with your payments, and what you monthly payment will be or how it will be calculated. When you borrow money from a lender, you usually will be charged interest.

Credit is issued on either a revolving basis or in installments. A revolving credit account comes with a credit limit – the maximum amount you can owe at any time. You must make the required minimum payment by the payment due date each month. Your available credit at any point in time becomes the difference between your credit limit and the total you owe. So if you have a $5,000 credit limit and you owe a balance of $800, your available credit (your amount available to use) is $4,200. An example of a revolving credit account is a credit card.

Credit in installments means that you borrow a set amount of money at one time and you make payments on a specific date and for a specific amount each month toward paying off the amount you borrowed plus any interest, fees and other charges. Once payments are complete, the installment loan account is closed. An example of an installment loan is a car loan.

Credit History

Credit history is important because it is how lenders determine whether they will give you a loan or credit card and what sort of interest rate you will be charged.

With a good credit history lenders should see:

Willingness to repay debts
A history of making other payments on time

A poor credit history will reveal:

Unwillingness to repay debts
A bad record or no record of making on-time payments

The Importance of Credit

The impact of good or bad credit is not simply in being approved or denied for a loan or credit card.

Interest charges – if you have a poor credit history, you will pay more – sometimes significantly more – in interest charges over the life of a loan or on a credit card account.
Employment – more and more some employers are running credit checks on potential employees as a way of measuring overall trustworthiness and personal integrity.
Housing – all home lenders and most apartment leasing companies run credit checks to determine creditworthiness before offering loans or providing leasing opportunities. A poor credit history could prevent you from finding a great place to live.

How Is Credit Measured

Most people who have taken out a loan or credit card will have a credit report establishing the person's credit repayment history from at least one of these three credit reporting agencies:

Equifax
TransUnion
Experian

These agencies collect information sent to them by creditors about your credit history. This information can include things like:

Your bill-paying history
How many accounts you have and what kind
Late payments
How long your accounts have been open
How much credit you are using versus how much you have available
Any collections efforts or actions against you
Your outstanding debt

Your report details your personal history in these areas and assigns you a credit score that lenders and credit card companies use to evaluate your credit worthiness. In general terms, a credit score falls into these ranges:

Excellent score 720-850
Good score 680-719
Fair score 640-679
Poor score 639 and below

As you build your credit history, your credit score increases or decreases based on your activity in applying for credit, using your credit and remitting payments.

How to Monitor Your Credit Report

It is a good idea, especially when applying for credit, to know what information currently appears on your credit report. You can obtain a copy of your credit report by contacting one or more credit reporting agencies. Each of these companies – Equifax, Experian, and TransUnion – is required to provide you with one free copy of your credit report once every 12 months.

However, do not contact them individually. They have set up a central website, toll free number, and mailing address at which you can order your free credit report:

Web: www.annualcreditreport.com

Mail: Annual Credit Report Request Service
PO Box 105281
Atlanta, GA 30348-5281

Establishing and Maintaining Good Credit

Getting started with credit may seem difficult but you can begin to build a credit history in several simple ways, such as:

Credit account with local store – sometimes local businesses are more willing to extend credit to those without credit history. Once an account is open, you can begin a pattern of making on-time payments that will help strengthen your credit history. However, you should be sure to ask whether your payment history will be reported to a credit bureau. The account has to appear on your credit report in order to impact your credit history and credit score.
Secured credit card – a secured card usually requires you to put up the money first and then lets you borrow a percentage of that amount.
Co-signing – other individuals with a more established credit history could co-sign on an account with you to help the lender feel more confident that the debt will be paid. This means the co-signer would be responsible to make payments on the account if you do not.

Once you have established a strong credit profile, you can maintain your good standing by following these guidelines:

Make payments on time, every time.
Avoid charging revolving accounts up to the limit or near the limit. A balance at or near the account limit on one or more accounts can have a negative impact to your credit score.
Be cautious in formally closing accounts. Doing so can impact your score positively or negatively depending on the other credit you have established and the characteristics of those accounts.
Avoid frequent applications for credit. Each application you make for credit is recorded on your credit report as an inquiry into your credit. Multiple inquiries over a short span of time can adversely affect your credit score.

Protecting Yourself While Using Credit

Credit is a useful financial tool when carefully managed. However, you should use caution to avoid specific credit traps and financial fraud that can be associated with making credit purchases.

Credit Traps

Scenario 1 – Some creditors mass-market to individuals with the promise of account approval. However, the terms of repayment often include a low minimum payment with a high interest rate. If only the minimum monthly payment is made, the account balance can grow quickly because the minimum payment may not cover any of the actual balance from the purchases you've made. Additionally, the minimum payment may not cover all of the interest that is being charged for the monthly payment. The result is an account balance that grows quickly even though you may not be making additional purchases.

Example:

You charge $1,000 worth of merchandise
Your card has a 19 percent interest rate
You make only $25 minimum payments and make no further purchases with your card
It will take you more than five years and cost you an extra $600 to pay off the debt

Scenario 2 – You might also be offered a deferred interest account. You will be charged no interest on purchases as long as you pay off your balance within the promotional period. However, if you do not, you will often be charged interest retroactively on all of your purchases at a high rate.

Example:

You open a credit account that offers zero percent interest for 12 months
After 12 months, the promotional period ends and a interest rate of 24 percent becomes effective
You make $1,000 in purchases before the promotional period expires
You are unable to pay the full balance off in the 12-month promotional period
You are now responsible for "retroactive" interest charges at 24 percent for the full $1,000 balance ($240), not just the remaining balance
Those interest charges continue to accrue with each month that the balance is not paid in full

In all cases, use caution and read the terms and disclosures carefully before opening a credit account.

Financial Fraud

Using credit cards can make purchases easier but also comes with the risk of financial fraud such as identity theft. To avoid someone else using your name to obtain credit or simply using your card in an unauthorized way to make purchases, keep these precautions in mind:

Never lend your card to anyone.
Never put your account number on the outside of an envelope or a postcard.
Always be cautious about disclosing your account number on the phone unless you know the person you're dealing with represents a reputable company and you initiated the call.
Always carry only the cards you anticipate using to prevent the possible loss or theft of all your cards or identification.
Always report lost or stolen card to the card issuer as soon as possible. Follow up with a letter that includes your account number, the date when you noticed the card was missing, and the date when you first reported the loss.

Common Credit Terms

Credit card – a card used to make purchases where repayment is made over time.
Charge card – a card used to make purchases where you must pay your balance in full when you get your regular statement.
Debit card – a card that allows you to access the money in your checking or savings account electronically to make purchases or to get cash.
Interest – the money that is charged by a lender to a borrower for the right to use borrowed funds.
Annual Percentage Rate (APR) – the APR is a measure of the cost of credit, expressed as a yearly interest rate. Usually, the lower the APR, the better for you. However, check the terms to ensure that your APR will not increase after a temporary promotional period.
Grace Period – this is the time between the date of the credit card purchase and the date the company starts charging you interest.
Annual fees – many credit card issuers charge an annual fee on their credit card accounts.
Transaction fees and other charges – most creditors charge a fee if you don't make a payment on time. Other common fees include those for cash advances and for going beyond the credit limit.

Resources

FEDERAL TRADE COMMISSION
Phone: 877-382-4357

The FTC works for the consumer to prevent fraudulent, deceptive, and unfair business practices in the marketplace. You can file a complaint with the FTC or find free information on things like credit card practices and identity theft protection.

FREE ANNUAL CREDIT REPORT
Mail: Annual Credit Report Request Service
PO Box 105281
Atlanta, GA 30348-5281

You can obtain a copy of your credit report and score by contacting the credit reporting agencies. Each of these companies – Equifax, Experian, and TransUnion – is required to provide you with one free copy of your credit report once every 12 months.

CONSUMER FINANCIAL PROTECTION BUREAU
Phone: 855-411-2372

The Consumer Financial Protection Bureau works to give consumers the information they need to understand the terms of their agreements with financial companies. You can find more information on paying for college, owning a home, getting mortgage relief, or filing a complaint if you believe you have been the victim of discrimination in a lending situation.