What are the basics of credit and types of credit?
Credit is an essential part of building a strong financial future. It evaluates your capacity to receive a credit line in the form of credit cards and loans. It also affects the cost of borrowing. While good credit can make getting a loan easier, bad credit can severely limit your options. Knowing the basics of credit and how it works will help you make good decisions and prepare you for a more successful financial future.
Here’s everything you need to better understand credit.
What are the basics of credit?
Credit is your capacity to obtain a credit line or borrow money. When you buy something on credit, you buy things with the money you borrowed, with a promise to pay them back by a specific deadline.
A history of on-time payments helps build consistent good credit. This is important for many reasons. This lays a good foundation for your financial health and determines whether you will have access to money in the future. It also affects the interest rate if you need to take out a mortgage, car loan or personal loan. You can maintain your good credit by consistently making your payments on time and getting progressively lower interest rates.
On the other hand, failure to make or default on your payments damages your credit history. This will make it difficult for you to borrow money or get a credit card in the future. Even if you are approved, you will have to pay a very high interest rate, which greatly increases the cost of borrowing.
Staying on top of your credit and working to improve is a smart financial strategy that will pay off in the long run. This shows potential lenders that you are a responsible borrower and are committed to paying your debts on time, which will open up more opportunities for you.
Types of credit
There are two main types of credit – installment and revolving credit.
Installment Credit – With installment credit, the lender offers a fixed amount of credit up front, and you agree to pay it back with interest in regular monthly installments over a specified period. The repayment period can range from several months to a few years, depending on the type of loan and the amount you owe. Loans, including student loans, mortgages, auto loans, and personal loans, are types of installment credit.
Revolving credit – With revolving credit, the money is not actually disbursed to you. Instead, you get a line of credit from the lender, up to a certain limit set by the lender after reviewing your financial credentials. You can borrow as per your requirements and you can borrow up to the credit limit set by the lender. Then you pay off everything you borrowed on a certain date each month. Once you pay off what you owe, your credit limit is reset for the next billing cycle, which is usually one month. The most common type of revolving credit is credit cards.
Although installment and revolving credit work differently, what matters in both is that the payment is made before the due date. Paying off what you borrow on time is the only aspect of building credit every time. This applies whether you have installment credit or revolving credit.
What is a credit report and how does it relate to your credit?
A credit report is basically a record that contains a complete history of your credit activities. This report is generated and maintained by the Credit Reporting Bureau.
When you pay off a loan or make a credit card payment, the lender reports it to three credit bureaus. The bureau notes your payment details and payment history on your credit report. Your credit report continues to grow as every payment detail is included. In addition to payment details, credit bureaus also receive reports on other credit activity, including new credit accounts you opened and old credit accounts you closed.
Missed payments, accounts sent to collections groups, bankruptcies, repossession, and foreclosures are also reported and recorded. This negative information remains on your credit report for at least seven years.
All of this reported activity is reflected in your credit report and ultimately compiles what develops in your credit history. Credit bureaus use the information from your credit report to calculate your credit score.