Introduction to Credit

Boy running father's credit card at supermarket
As a child watching an adult make credit card purchases, you might have assumed that the cards had some type of magical power that let people buy things without having to actually spend money. Monashee Frantz / Getty Images

As a child watching an adult make credit card purchases, you might have assumed that the cards had some type of magical power that let people buy things without having to actually spend money. Some card-carrying adults still have the same assumption. If you haven’t figured it out yet, here’s one fact about credit that you must know: it’s not a cash substitute, but rather a loan that you must pay back with money you earn for days, weeks, and years to come.

What is Credit?

Whenever you make a purchase today with the promise to pay for it tomorrow, you are using credit. Before credit cards became so common, merchants had their own credit accounts. Our grandparents, or some parents, might go to the market, pick up groceries for this week, and promise to pay the bill next when they received their salary. The grocer was extending credit.

If your grandparent always paid their bill on time, the grocer might not have a problem letting them pick up more groceries. However, if your grandparent didn’t settle the bill, the grocer might cut off the credit line and require your grandparent to pay for their groceries on the spot.

Credit has been standardized over the years and many stores belong to corporations that won’t allow people to purchase goods unless they pay on the spot with cash, check, or a major credit card. No more promises to pay.

Now big banks control whether you can use credit and how much you can use.

Before a bank will allow you to use credit, it must first believe that you can be trusted to repay the amount of credit you use. This is considered financial trustworthiness.

Lenders use a number of factors to determine your financial trustworthiness and it’s not based on how long they’ve known your family.

Your credit history is one of the most commonly used factors. How you have used credit in the past – your credit history – is considered to be the best way to predict how you will use it in the future. Your credit history is reported in your credit report and measured by your credit score.

Lenders also consider your income. Do you make enough money to pay back what you’ve borrowed? Even with a good history of repaying what you borrow, lenders want to know that you actually have (or will have) the means to pay back the credit you use.

For new borrowers without a credit history, lenders may place more importance on your income. They may only give you a small amount of credit to start out with and increase your credit as you demonstrate you can handle it.

If you’re a new borrower or you’ve had credit problems in the past, the lender might require someone who has a favorable credit history to co-sign with you. The co-signer essentially agrees to repay credit charges when the other person fails to do so. Both borrowers share credit.

How Does Credit Work?

To establish credit with a financial institution, you must first make an application. The lender will use identifying information, like your social security number, to look up your credit history with credit bureaus.

Credit bureaus, or credit reporting agencies, are companies who keep track of your credit history – credit accounts you’ve had, the amount you borrowed, and whether your payments were late or on time. If the lender determines that you are a trustworthy borrower, then it will extend credit to you.

Once you have been approved for credit, the lender will give you guidelines, or terms, for using your credit. The terms include, but are not limited to, how much you can borrow, whether you can borrow money just one time (a loan) or keep using the same credit over and over (a credit limit or credit line), how often you should send payments for purchases, what happens if you are late on a payment, and the cost of using credit.

Usually, the lender establishes a maximum amount of credit that you can use, a credit limit, based on your credit history. Your credit terms will outline what happens if you exceed your limit. In some cases, there is a monetary penalty.

When you’ve been approved for revolving credit that you can use over and over, the lender provides you with a way to use this credit, e.g. a credit card or a checkbook. Periodically you will receive a billing statement from your lender detailing purchases you’ve made, interest charged, minimum payment amount due, and payment due date. Per your agreement with the lender, you must make payments by the due date to avoid penalties.

Learning More About Credit

Now that you understand more about credit and how it works, you’re ready to learn about why good credit matters, how you can get credit even for the first time, and how to build good credit.