What Is Credit and How Does it Work?
- Credit can mean borrowing money and paying it back over time. Credit cards, car loans, mortgages and personal loans are all types of credit.
- Credit can also mean how you handle your money, with your credit score measuring how responsible you are when you borrow.
What is credit?
“Credit” is when you borrow money with the promise to pay it back. The amount you owe is your debt, and having debt lets you own or use something before you have the money to pay for it.
“Credit” can also mean how you handle the money you borrow — for example, whether you repay your debt and make payments on time.
We’ll cover how credit works — including credit scores and types of credit — and why it matters.
How credit scores and reports work
Your credit report is a history of your credit, including past payments. Your credit score is a three-digit number that measures how well you manage your debts.
Here’s how they work:
- Lenders report your credit activity. Every month, your credit card company or lender reports information, like how much you owe and whether you’re making on-time payments. These updates go to companies that track your credit, usually called credit bureaus.
- Credit bureaus update your credit reports. The three major credit bureaus (Equifax, TransUnion and Experian) collect data from your creditors and add that information to your credit report.
- Your credit score may change based on your report. Your credit score is like a grade for your credit. Every month, credit scoring companies like FICO and VantageScore use information from your latest credit reports to calculate your current credit score.
Check your credit score for free with LendingTree Spring. You’ll get personalized recommendations on how to boost your score, and you can use Spring to track your score over time.
Why do credit scores and reports matter?
Bad credit can keep you trapped in a cycle of debt with less access to housing and employment. Good credit, on the other hand, can save you money and give you better opportunities.
Here’s how having better credit can help you:
Save money
Lower rates. Lenders and credit card companies give their best rates to people with excellent credit. Lower rates save you money on interest.
Raising your score from “fair” to “very good” could save you over $39,000 across different types of debt like credit cards, car loans, mortgages and personal loans.
Cheaper insurance. In most states, car insurance companies use your credit score to decide how much to charge you. You can save money with better credit.
Avoid security deposits. Having good credit can make it easier to get housing utilities and avoid paying a deposit to get services like electricity and gas.
Improve opportunities
Better odds of approval. The better your credit, the more likely you are to be approved for credit cards, loans and mortgages.
More housing options. When you apply for a lease, your potential landlord can run a credit check. The better your credit, the more likely they’ll approve you.
Pass employment checks. For some jobs, the company might run an employment credit check when you apply to work there. The employer won’t see your credit score, but as long as you live in a state where it’s legal, they can use the information in your credit report to decide whether to hire you.
Learn how to build credit from scratch and how to improve your credit to make the most of your money.
How using credit to borrow money works
Without credit, you’d have to save up for all of your purchases before you make them. This would make buying a house or car difficult or impossible for most people.
But credit usually isn’t free. When you borrow money with credit, you usually pay it back with interest.
So how does credit work? There are three different types of credit — revolving credit, installment credit and open credit. Here are examples of each:
Credit cards
(Revolving credit)
What is it? Credit cards are revolving credit, meaning they let you borrow and repay money over and over again.
How does it work? You use your physical card or your credit card number to make purchases, pay bills or even get cash.
Cost to borrow: You can usually borrow money with your credit card without any interest by paying off your card every month (though you might pay credit card fees).
Or you can just make the minimum payment and owe interest on the amount you haven’t paid.
How interest works: Credit cards usually charge interest daily on any balance you carry from the previous month(s).
Other examples of revolving credit: Lines of credit and home equity lines of credit
Learn more about how to use a credit card.
Loans
(Installment credit)
What is it? When you get a loan, you borrow a lump sum of money once and pay it back over time.
How does it work? Your lender sends you the funds, which you use to make a big purchase or even pay off other debt.
You pay the lender back over time, usually in equal monthly payments.
Cost to borrow: The interest and fees for your loan are called the annual percentage rate (APR). This is the total cost of your loan.
How interest works: Lenders calculate your APR at the start of your loan. Different lenders offer different rates.
You’ll pay the APR, plus what you borrowed, over the course of the loan. Your payments will often be the same every month.
Examples of installment credit: Mortgages, car loans, personal loans and student loans
Learn more about how installment loans work.
Service credit
(Open credit)
What is it? With service credits, you use services like your cell phone or home utilities, and then pay a bill for them afterward. This is also called open credit.
How does it work? Think of it like a bar tab for the services you use. You pay for what you use, typically at the end of the month.
Cost to borrow: None, but you’ll likely pay fees if you miss a payment.
Examples of open credit: Utilities, cell phones and charge cards
Why does understanding credit matter?
You can save a huge chunk of change just by knowing how borrowing money with credit works.
Consider credit cards for example. Making minimum payments on your credit card could cost you thousands, but you can pay $0 in interest by paying your full balance every month.
Or consider loans. Knowing to shop around for lower interest rates can save you a lot of money. Recent LendingTree studies show that comparing offers from multiple lenders can save you over $3,000 on a personal loan, over $5,000 on a car loan and over $76,000 on a mortgage.
Frequently asked questions
Credit can mean (1) borrowing money with the agreement to pay it back later, or (2) how you borrow money and pay it back over time.
When you pay for something with credit, you’re using money from a lender that you’ve agreed to pay back later. When you pay for something with a debit card, the money comes directly out of your bank account.
Choosing between debit or credit depends on different factors. For example, using credit builds your credit, but using a debit card doesn’t.
Using credit to borrow money helps you:
- Buy things you can’t afford yet and pay them back over time.
- Build your credit history and score with responsible borrowing.
Credit helps everyday people afford expensive purchases like their homes, cars, college tuition and even medical bills.
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