What Is Credit and Why Do You Need It?

Credit is defined as the ability to borrow money to pay back later. A good credit history gives you more options.
Amanda Barroso
By Amanda Barroso 
Edited by Kathy Hinson

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Key takeaways:

  • Credit is defined as an arrangement that allows you to borrow money now and repay it later.

  • If you have good credit, as shown by your previous financial behavior, then it’s easier to borrow money.

  • You can build your credit over time.

The definition of credit is the ability to borrow money with the promise that you'll repay it in the future, often with interest. You might need credit to purchase a product or use a service that you can’t pay for immediately.

While credit comes in many forms, the most common are credit cards and home, car and student loans. You must apply for credit, and the amount you're authorized to use is determined by lending institutions (like banks or mortgage companies) based on your personal financial history.

Having good credit makes it easier to do many things, including rent an apartment or buy a home or car; sign up for a cell phone plan; or get a student loan. With good credit, you can even save money in the form of lower interest rates or waived fees and down payments when setting up utilities.

Credit definition

Credit can mean either borrowing money or getting something of value, like a car, with the commitment to repay later and often with interest charged. It can also mean your ability to borrow or buy things on a credit contract.

Your credit report and credit score are two ways your access to credit is defined.

Your credit report contains a history of your financial behavior, as well as personal information like your employer and current and previous home addresses. The report lists:

  • The number of open accounts you have, along with the current balances.

  • Your payment history, including any late or missed payments.

  • Loans you've taken out and the remaining balances.

  • Any financial disruptions like a bankruptcy or foreclosure.

Financial institutions can report your activity to some or all three of the major credit bureaus: Equifax, TransUnion and Experian. Each bureau produces a credit report that you can access for free by using AnnualCreditReport.com.

Monitoring your credit reports and looking for discrepancies is a good habit to create. If you find an error, you can dispute it with the credit bureau. If an investigation is ruled in your favor, the fixed error could have a positive impact on your credit score.

Your credit score is a three-digit number typically ranging from 300 to 850. It distills your credit history and other components of your credit report into a shorthand used by financial institutions to determine your creditworthiness.

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Types of credit

There are many types of credit, but two are most popular: revolving and installment credit.

Revolving credit

Revolving credit is a type of credit, typically issued in the form of a credit card, where users are given a credit limit but can spend as much or as little up to that amount as they want. Balances are paid off in full or in part each month, and any remaining balance is carried over (or revolved) to the following month. Credit cards are different from charge cards — another type of credit — where the balance must be paid in full each month.

Installment credit

Installment credit is a type of credit, usually issued in the form of a loan, that borrowers pay back in steady increments over time. Examples of installment credit include student loans, car loans and mortgages.

Service credit

Service credit is a type of credit that describes contracts you enter into with many service providers, like utility companies and membership services. These companies provide the service and you sign a contract to pay them after the fact. Your cell phone plan, electric bill and gym membership all fall into this category.

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How to build your credit

Whether you’re starting from scratch or want to build stronger credit, here are a few strategies to get you going.

If you don’t have credit but are looking to build it

  • Become an authorized user on the account of a trusted family member or spouse who has a long, responsible credit history. By having your name attached to their line of credit, you can reap the benefits without worrying about the responsibility of payment.

  • If you can’t get a credit card because you have limited or bad credit, try a secured card. These cards require an upfront deposit, and lenders can take that deposit back if you don’t pay the balance in a timely manner. After you’ve established a history of paying on time, you can look into upgrading to an unsecured card.

  • Try a credit-builder loan, where lenders (frequently community banks and credit unions, in this case) hold the money you pay in an account until the full amount is repaid, then release it back to you.

If you have credit but want to strengthen your score

  • Be sure to make payments on time. Make at least the minimum payments to avoid being hit with a penalty for a missed payment.

  • Keep your credit utilization low (under 30% is good but less than 10% is ideal).

  • Keep credit accounts open, especially your most long-standing accounts. Your credit history takes into account your average account age, so it's a good idea to keep your first credit card open (even if you don’t use it much now).

  • Don’t apply for too many lines of credit at once. NerdWallet recommends spacing credit applications about six months apart.