What is credit and how does it work?

Credit allows you to make purchases even when you don’t have cash on hand. But that’s not the only way credit can be a helpful financial tool.

Build your financial literacy by learning more about what credit is and what it can do for you.

Key takeaways

• Credit allows you to get money upfront with the promise to repay it in the future, often with interest.
• Creditworthiness refers to a borrower’s ability to repay what they’ve borrowed.
• Lenders judge creditworthiness in many different ways. And they may use things like credit reports and credit scores to help.
• Credit comes in different forms, including revolving credit and installment credit.

The term credit can be a reference to more than just the act of borrowing money and repaying it. Here are some other credit-related terms that can help explain how it all works:

Your credit history details how you borrow and use money. If you hear someone talking about credit bureaus, credit reporting agencies or consumer reporting companies, they’re probably talking about Equifax®, Experian® and TransUnion®. Those are three national organizations that track credit history and compile credit reports.

A credit report is a record of your credit history. Credit reports include details like payment history, credit inquiries and other information collected by the three nationwide credit bureaus.

Creditworthiness describes a borrower’s ability to pay back credit and loans. If you’re wondering whether you have good credit or bad credit, you’re talking about creditworthiness. 

Your creditworthiness is typically based on your credit history. And it can affect your approval odds and the terms of a loan, including fees and interest rates.

A credit score is one measure of creditworthiness. It’s typically a number between 300 and 850 that’s based on the information in your credit reports.

Credit scores are calculated using mathematical formulas that factor in payment history, length of credit history, credit mix, credit utilization and more. There are multiple credit scores out there. But the most common credit score models are FICO® and VantageScore®.

Generally speaking, credit works like this: A lender, such as a bank or credit card issuer, approves a borrower’s request to borrow a certain amount of money. In exchange for the money, the borrower agrees to pay it back to the lender, typically with interest.

That money might be available as a line of credit, like a credit card. Or it might be a lump sum, like a personal loan or auto loan.

Credit is often classified in two ways: revolving or installment. Here’s a closer look at each.

Revolving credit is an open-ended form of credit. This means you can borrow from the account and pay the money back for as long as the account is open and in good standing. 

Revolving credit accounts typically have a credit limit, or a maximum amount that you can borrow at any given time. Each time you borrow money, the amount available to you decreases. And each time you make a payment, your available balance goes back up.

Credit cards, charge cards and home equity lines of credit (HELOCs) are common examples of revolving credit.

Installment credit accounts, also known as installment loans, are closed-ended. This type of credit is usually paid back on a fixed timeline and at a fixed monthly amount, often with interest.

Mortgages, car loans, student loans and personal loans all are examples of installment credit.

Credit is important for a number of reasons. 

• Accessing credit might be the easiest way for you to make a large purchase, such as a car or a home. 
• How you use existing credit determines what goes into your credit reports, which influence your credit scores.
• Your credit reports and scores are a reflection of creditworthiness, which lenders use to determine whether to approve loans and what terms to offer.
• Banks, credit card issuers and other lenders aren’t the only ones that might consider your creditworthiness. Landlords, insurance companies and even employers may make decisions based on your credit.

Because credit can play such a huge role in shaping your overall financial profile, it’s important to develop healthy credit habits that can help you build and maintain good credit scores over time.

If you’re talking about your credit reports and scores, you can monitor your credit with CreditWise from Capital One. It’s free, and you don’t have to be a Capital One customer to use it. Plus, using it won’t hurt your credit scores. You can also visit AnnualCreditReport.com to learn about how to get free copies of your credit reports.

If you want to know about the status of certain credit accounts, your loan or credit card statements are a good place to start.

Credit isn’t just a way to borrow money—it may also refer to credit history and creditworthiness. But no matter how you think of credit, managing it responsibly can be important to your financial well-being. 

Once you’ve got the credit basics down, you can learn how to start building credit or explore how you can use a credit card to build credit with responsible use.