It's something most Americans can't live without. The problem is, nobody really wants to talk about it. Credit is the ability to borrow money (or other services) with the agreement that you'll pay it back later. Credit can take many different forms — credit cards, loans, mortgages, etc — but the principle is generally the same. You apply for credit from a bank or another lender.
Before we go any further, here are some facts about credit that will surprise you.
- More than 189 million Americans have credit cards.
- The average person in the United States has four credit cards.
- Around 40 percent of all homes in the U.S. have a mortgage.
As you can see, applying for credit is very, very common. However, some Americans find it more difficult to get credit than others. We'll explain why this is the case a little later on.
What is Credit, Really?
Credit. Six letters that could change your life. Without it, you might not be able to buy a car or a home. You might not be able to pay for a new laptop or TV. You might not be able to pay for all the things you need in your life.
Credit reference agency Experian provides the following definition for the term credit:
“Credit is the ability to borrow money or access goods or services with the understanding that you'll pay later.”
It's as simple as that. If you can't afford to buy something now, you probably need credit. With credit, you can pay for things now instead of waiting. However, you will need to pay this money back.
There are various types of credit, but the following are the most common:
- Credit cards
- Loans
- Mortgages
There are many companies that provide credit as well, but the following are the most common:
- Banks
- Credit card companies
- Merchants/retailers
- Service providers
Companies that offer credit are often called creditors. The money you owe creditors is called debt.
How Does Credit Work?
The concept of credit has been around for centuries. Today, it's an important component of the American financial system. Many Americans can't afford to pay for large purchases (like a car or home) in one go. This is why they might need to apply for credit. In other scenarios, people need extra money because of a shortfall of funds or emergency situations. Again, they might need to apply for credit.
"When you use credit, it usually means using a credit card. It also might mean that you get a loan. A loan is another way to use credit. Using credit means you borrow money to buy something," says the Federal Trade Commission.
Some people find it easier to borrow money than others. This is because creditors want to know if a person can pay the money back. These creditors might look into something called a credit history.
Everyone has a credit history. It tells creditors whether a person is likely to pay the money back on time. Someone's credit history is based on whether they paid credit back on time in the past.
Creditors will usually use one of three different companies to find out someone's credit history. These companies are:
The companies above evaluate someone's credit history and assign them something called a credit score. This score helps creditors decide whether a person is likely to make repayments on time. (We will discuss credit scores another day!)
But this isn't the only thing they look at. Creditors will have their own internal borrowing policies too.
When you take out credit, the creditor will expect you to pay small installments every month. These are called repayments. You will continue to make repayments every month until you have paid off your debt in full.
What is Interest?
You might be wondering why creditors let people borrow their money. Well, this is where something called interest comes in. Interest is something you pay when you borrow money. However, different creditors charge different levels of interest (interest rates), so some people pay less, while others pay more.
All types of credit have different interest rates. Usually, the interest rate is called the annual percentage rate (APR). This might sound complicated, but it's not. Basically, it's the amount of interest you pay over the year.
For example:
- You take out a $100 loan for 12 months.
- The loan has a 2% APR.
- You pay back $102 after the 12 months. (The original $100 loan and $2 in interest. 100+2=102).
"A lower interest rate means you pay less money. A higher interest rate means you pay more money," says the Federal Trade Commission. "For example, a loan with a 2% interest rate costs less than a loan with an 18% interest rate."
Why is Credit Important?
Credit is important because it gives you more financial freedom. There might be times in your life when you can't afford to buy something, especially something expensive, and this is completely normal. With credit, you can buy things now and pay for them later.
Credit is particularly useful if you want to buy a large purchase such as a car or home. Many Americans don't have the money to pay for these items in full so they need to take out credit and make monthly repayments.
Final Word
As you can see, credit isn't as complicated as it sounds. However, it is important. If you have a poor credit history or no credit history at all, you might want to improve your credit. This is where we can help. Here at Credit Innovation Group, we help you develop something called a credit profile, which lets you secure the credit you need.
