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Published 14 December 2023
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9 minutes

What Is Credit and How Does it Affect Your Financial Life?

Credit is defined as the ability to borrow money to pay back later. A good credit history gives you more options.

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Key takeaways: 

Common credit products include credit cards, mortgages and loans. You have to apply for credit, and the amount you can borrow is decided by the financial institution lending it to you (such as a bank or building society) based on your financial history and current situation.

Having a good credit history can make it easier to be approved for new credit, because it suggests that you will make payments on time. Your credit history might be checked in other situations, too – for example, when you’re applying to rent a new property, or before you start a new job. This can help to prove that you’re reliable.

Credit definition

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 use credit to purchase a product or use a service that you can’t pay for immediately.

You can use some forms of credit to pay for smaller, everyday purchases. Or you might want to apply for other forms to finance large purchases, such as a car or home improvements.

It’s up to lenders to decide whether to offer you credit. Your credit report and credit score are two ways your ability to access credit is determined.

Your credit report contains a history of your financial behaviour, as well as current and previous home addresses. It lists:

Financial institutions can report your activity to some or all three of the major credit reference agencies – Equifax, TransUnion and Experian. You can request a free statutory credit report from these agencies, which can give you a basic understanding of your credit history. 

Monitoring your credit reports and looking for discrepancies is a good habit to get into. If you find an error, you can dispute it with the financial business or credit reference agency. If an investigation is ruled in your favour, the fixed error could have a positive impact on your credit score.

Your credit score is a three-digit number. It distils your credit history and other components of your credit report into a shorthand used by financial institutions to determine your creditworthiness. You may have to pay to get your credit score from credit reference agencies, but some organisations such as Credit Karma, ClearScore and TotallyMoney can give you a free credit score if you sign up.

Your score can range from 0-999, depending on the credit reference agency, and a good score will fall in different ranges for each.

Types of credit

There are many types of credit in the UK. For example, you could borrow money in the form of credit cards, store cards, and overdrafts to make everyday purchases. Types of credit for larger purchases include secured loans and mortgages.

For all types of credit, it’s important that you understand the agreement that you’re entering into. Check how repayments work and that you can afford to keep up with them. 

Some types of credit might be more suitable for your situation than others, so research your options carefully.

Credit cards

You can use credit cards in the same way as debit cards, paying for purchases online and in-store.

When you apply for a credit card, the bank or lender will set a credit limit, which is the maximum amount you can borrow at any one time. When you buy something, it gets added to your balance.

You have to make a minimum payment each month to keep the account up to date and to avoid any penalty fees. But ideally you should aim to pay more than this. If you don’t clear your balance in full each month, you will usually be charged interest on the remaining amount. The lender sets this interest rate when you apply.

» MORE: How do credit cards work?

Store cards 

Store cards work in a similar way to credit cards, but you can typically only use them with one retailer. They often come with incentives to get you to sign up, like vouchers to use in-store. The interest rate is usually higher than normal credit cards.

Some stores, such as Tesco and Sainsbury’s, offer branded credit cards that are linked with their loyalty schemes, but these are not store cards – you can use them anywhere you like.

Some retailers also offer catalogue credit when making purchases by post or online, and it allows you to spread the cost of an order over a number of instalments.

Overdrafts

An overdraft gives you the ability to borrow money from your bank through your current account. It can be useful in emergency situations.

You may have to ask for an overdraft, or you might be given one automatically. It depends on the bank. You will usually be charged interest for using your overdraft and you may have to pay fees if you enter your overdraft without arranging it with your bank first.

Loans 

Broadly, loans let you borrow money and pay it back in instalments, over a set period known as the loan term. These instalments include interest. Usually, the longer the loan term, the more interest you pay. There are many types of loans. 

Unsecured loans aren’t secured against anything you own, meaning your assets won’t initially be at risk if you fall behind on repayments.

Secured loans use an asset, often your home, as security, meaning you could lose it if you don’t make your repayments. You may be able to access larger sums of money, but the risk to you is larger too.

» MORE: Secured and unsecured loans: what’s the difference?

Mortgages

A mortgage is a loan that you take out to buy a property and it is typically paid back over a number of years. Many banks and building societies offer mortgages. Your monthly instalments will pay off the amount you borrowed and interest. 

You can also get an interest-only mortgage, where the instalments only pay off the interest. At the end of the mortgage, you then need a way to pay off the full amount you borrowed.

Before agreeing to give you a mortgage, lenders will make sure that you can make the repayments, which involves checking your credit history.

» MORE: Mortgage eligibility: everything you need to know

Other types of credit

The above is just an overview of the types of credit available in the UK. Other credit agreements you might come across include hire purchase – often used to buy cars – and buy now, pay later.

Even getting a new phone on contract is a type of credit, as the monthly payments can cover both your usage and the cost of the phone. 

How to build your credit history

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

If you’re just starting out

First, lenders will want to confirm your name and address, so it can help to get on the electoral roll. This registers you to vote in the UK and lenders can access it to check your details.

Opening a bank account and paying bills from that account on time by direct debit will be recorded on your credit history, showing that you’re able to manage your money.

Using a credit card responsibly can help to build your credit history. However, missing payments will impact your score and put you into debt, so it’s important to work out whether applying for a credit card is right for you. Only making minimum payments means you’ll be charged interest.

Otherwise, smaller types of credit, such as mobile phone contracts, can also start building your credit history. Again, it’s important that you’re able to make – and keep up with – your payments.

If you want to strengthen your history

Be sure to make payments on time. Make at least the minimum payments to avoid being hit with a penalty for a missed payment. But remember, only making the minimum payments on a credit card means that you’ll be charged interest on the remaining balance, costing you in the long run.

With credit cards, using too much of your available limit can affect your credit report negatively. Try to keep the percentage you use low.

Applying for too much credit at once shows on your credit report and can make it seem like you’re relying on credit to manage your financial situation. Spacing out applications is often preferable.

You should also check whether your credit history is linked with someone else’s, for instance an ex-partner. If they’ve got a bad credit history, it can affect yours. 

Your histories might be linked if you held a joint account or a mortgage with them. To unlink them, you would need to speak to the credit reference agency.

Get free expert debt advice

Remember that by taking out credit, you’ll be in debt to the lender. As mentioned, using credit responsibly can help you build your credit history, while being in too much debt could impact you negatively.

That’s why it’s important to understand the different types of debt and the impact that debt can have on your situation.

If you’re struggling with debt, there are free, independent debt advice services and debt charities that you can speak to, such as Citizens Advice and StepChange.

Image source: Getty Images

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