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The definition of credit and why you need it

Last Updated: September 12, 2023
4 min read

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Key Points About: What Is Credit?

  1. Credit is a system that allows you to borrow money to make purchases on the condition that you pay it back.

  2. Lenders determine whether to give you credit based on your credit score and the information in your credit report.

  3. You can take steps to improve your credit by practicing responsible credit habits, like paying your bills on-time, and keeping your credit usage low.

Credit allows you to borrow money from a lender for purchases on the condition that you’ll pay back the money later. Credit is one way that you can increase your spending power beyond the cash you have on hand or in the bank. 

Two common forms of credit are revolving credit and installment credit. 

Revolving credit: As the name implies, revolving credit is a type of credit that is ongoing. In other words, it’s a line of credit that you can borrow against as often as you like, if you pay at least the minimum amount due on your bill and remain within your credit limit. One of the most common forms of revolving credit is credit cards

Installment credit: Installment credit, on the other hand, is a fixed sum of money a lender gives you with a fixed repayment term. These are also sometimes called installment loans and can include things like student loans and personal loans.

Did you know?

You can build your credit history with the Discover it Secured Credit Card.1

Learn more

How does credit work?

Your ability to manage different forms of credit responsibly may impact your creditworthiness. Lenders want to determine your creditworthiness before extending you credit, so they look at your credit report and credit score. 

Credit Score: According to the Consumer Financial Protection Bureau, your credit score is a three-digit number that helps predict your future credit behavior. In other words, it looks at your past behavior as a borrower to determine your credit risk (how likely you are to pay your debt on time) based on what’s on your credit report.

Credit Report: A credit report is a document that has information about your credit history—your borrowing activity past and present like your loan paying history and the status of your credit accounts.

You probably have more than one credit report, that’s because there are multiple credit reporting agencies (the three major agencies are Equifax, Experian, and TransUnion).

Why is good credit important?

A high credit score or good credit score may show lenders that you practice good financial habits, like paying your bills on time and keeping your credit utilization low. While a low or poor credit score may signal more credit risk. 

Ultimately, whether you’re approved for credit can depend on multiple factors, and how lenders judge your credit score may vary. But there are some steps you can take to help improve your credit score.

When do I need credit?

Your credit score may come into play in the following situations: 

Credit cards

When you apply for a credit card, the credit card company may run your credit. Good credit may give you more card options on better terms, like a higher credit limit and a lower annual percentage rate (APR).

Mortgages and auto loans

You may also need credit when you try to buy a home or car. Having good credit may help you qualify to borrow—and at a lower interest rate. Interest rates are important, because the higher your rate, the more you may end up paying over the life of the loan.

Rental housing 

When you apply to rent an apartment or house, the landlord may check your credit history. Even if you don’t have perfect credit, you may still qualify to rent, but according to the Consumer.gov, you may have to pay more rent in advance.  

Utilities and cell phone contracts

Your credit may also be a factor when you set up utilities or get a new cell phone contract. According to the Federal Trade Commission, if you have a low credit score, you may be asked to pay a security deposit for your utilities.

How can I improve my credit?

Even if you don’t have the best credit or believe you have “bad credit” you may still be able to improve your credit with responsible borrower behavior and practicing good credit habits:

Make on-time payments

Your payment history is an important part of your credit score. You should aim to pay your bills on time, every time. A missed payment can impact your credit score and a history of late payments may show credit providers you have trouble paying back your debts. 

Keep your credit card balances low

The amount of credit that you’re using versus the amount of credit that you have available is called your credit utilization. Your credit utilization typically makes up 30% of your credit score.

Monitor your credit report

It’s important to regularly check your credit report for any errors or activity you don’t recognize, because these may be a sign of identity theft. If you see an error on your credit report, you can dispute it with the credit bureaus or the creditor directly. If the credit reporting agency or the creditor confirms that an error happened, and the error is removed from your credit report.

Where can I find my credit report?

You can obtain your credit report for free from each of the major credit reporting agencies (Experian, TransUnion, and Equifax) once every 12 months by visiting annualcreditreport.com.

Credit can help you get the funds you need to invest in your future, whether it’s purchasing a new home, buying a new car, or starting a new business. It’s essential to understand the importance of maintaining good credit and managing debts responsibly.

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