What is Credit?

If you need to cover the cost of emergency expenses or large purchases you may need to consider using credit. Read on to find out what credit is and the different types available.

Brean Horne Published on 06 October 2021.
What is Credit?

Credit allows you to borrow money for purchases and repay it at a later date.

It can help you cover unexpected costs or large purchases when you don’t have all of the money to hand up front.

Here, we explain how credit works and the different types you can apply for.

What is credit?

A credit agreement is essentially a type of borrowing that allows you to access funds with the promise that you will pay it back at a later date.

When you use credit, you are in debt to the lender. And you will have to repay the money, often with interest added on top.

Many lenders will use a hard credit check to look at your credit history when deciding whether to lend you money. Typically, lenders are more likely to approve credit applications from customers with a good credit score. That is because it shows you have a good track record of managing repayments and clearing your debt.

» MORE: What is a credit score?

What are the different types of credit?

There are lots of different types of credit available, which include these common forms of credit agreement:

Loans

A loan is when you borrow a set amount of money and agree to repay it with interest by a certain date or over a set period of time.

Personal loans fall into two categories, secured and unsecured. Secured loans require you to put down an asset, such as a car or high-value jewellery, as collateral, in case you can’t repay your loan.

Unsecured loans don’t require you to put down an asset, but tend to charge more expensive interest rates and let you borrow less money.

» COMPARE: Personal loan deals

Buy now, pay later

Buy now, pay later (BNPL) is a type of credit agreement that lets you pay for shopping at a later date, rather than covering the cost up front.

Most BNPL schemes let you spread the cost of your shopping over several months or delay paying until a later date, interest-free.

BNPL could help you manage your finances by spreading the cost of your shopping without incurring interest. But missing payments could result in late fees and interest being added to your repayments, as well as damage to your credit score.

Mortgages

A mortgage is a type of secured loan that is designed to help you buy a property.

Usually, when you apply for a mortgage you will need to put down a deposit, which is a percentage of the value of the property. The mortgage covers the remaining cost. You will have to pay off your mortgage, with interest, over a period of time agreed with your lender.

There are two main types of mortgages: fixed rate and variable rate. Fixed-rate mortgage deals keep the amount of interest added to your repayments the same for a certain period of time.

Variable rate mortgages offer interest rates that change over the course of your mortgage, which means that your repayments could become cheaper or more expensive month to month.

» COMPARE: Mortgage rates and deals

Credit cards

A credit card lets you pay for goods and services without cash (you can also withdraw money from a cash machine). You will be sent the bill for your purchases and withdrawals at the end of each month. When you apply for a credit card, your lender will give you a credit card limit, which is the maximum amount of money you can spend on the card.

You can choose to pay off your credit card bill in full each month or make the minimum monthly repayment. If you don’t pay off your credit card bill in full each month, interest may be added to your bill. If you make a late payment or miss repayments, you may also be charged a fee. Think carefully before using credit cards as this type of debt can be expensive and quickly spiral out of control.

There are many types of credit cards to choose from. For example, a 0% interest credit card lets you spend without incurring interest for a certain period of time, while a rewards credit card lets you earn points, discounts or cashback when you spend.

Overdrafts

An overdraft lets you borrow money through your current account. It works by letting you spend more than the available balance in your account.

For example, if you had no money left in your bank account and needed to make a purchase for £40, your overdraft would let you borrow money to make that purchase. Your account balance would be -£40 after the purchase, to show that you are using an overdraft.

There are two types of overdrafts: arranged and unarranged. Arranged overdrafts are when you agree in advance on an overdraft limit with your bank.

Unarranged overdrafts are when you spend more than your account balance without agreeing one with your bank first, or when you go over an agreed overdraft limit.

Banks now charge the same flat interest rate for both arranged and unarranged overdrafts, due to recent rule changes to make overdraft fees clearer for customers. Overdraft interest varies depending on your bank, but in some cases it can be almost 40%.

» COMPARE: Bank account with overdraft deals

Should I use credit?

Using credit can help you cover the cost of goods and services when you don’t have all of the money to pay up front.

This can be particularly useful for unexpected costs such as a boiler breakdown, or for big purchases – buying a house, for example.

Managing your credit repayments can also help to improve your credit score, which will improve your chances of being accepted for new credit with cheaper interest in the future.

But before applying for credit it is important to make sure that you can afford the repayments. Although credit gives you access to funds, you will have to pay the money back, often with interest.

Not paying off your debts can damage your credit score, which reduces your chances of being approved for credit in the future. Missed or late payments are recorded on your credit file for up to six years and can be viewed by other lenders if they run a hard credit search when you apply for credit.

Lenders may also take out a county court judgment (CCJ) against you and use debt enforcement agents to recover what you owe, which would be a distressing experience.

» MORE: What is a credit score?

Why have I been refused credit?

There are lots of reasons why you may have been refused credit, including:

  • Poor credit history: Many providers run a hard credit check when you apply for new credit, such as a mortgage or credit card. Lenders are less likely to approve applications if you don’t have a good track record of paying off debt because there is a greater risk that you won’t be able to pay them back.
  • No credit history: If you haven’t used much credit in the past, lenders won’t have enough data to prove that you are good at repaying your debt. This could make them reluctant to approve your application. Taking steps to improve your credit score could help boost your chances of getting credit in the future.
  • ID issues: Your credit application may be rejected if the lender can’t confirm your identity or address. This may occur if there were errors in your application, or if you didn’t send the right documents in time. It is worth speaking to the lender to see if you can reapply with the correct details.
  • Affordability: Almost all lenders have to consider whether you can afford to borrow money in the long term when considering your application. So your application may be rejected, even if you have a good credit score because you don’t pass the affordability checks. Currently, the exception to this is buy now, pay later schemes. However, they too will need to consider affordability once they fall under FCA regulation in the future.

Image source: Getty Images

About the author:

Brean is a personal finance writer at NerdWallet. She covers a range of financial topics and has written for consumer titles including Which?, Moneywise and The Motley Fool. Read more

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