Credit — [noun] The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.
Debt — [noun] A sum of money that is owed or due.
Credit is a concept which exists through a handful of more practical ideas. This includes credit cards, auto and home loans to name some. Ultimately, utilizing credit can enable you to access something now that you can’t entirely afford with the money you currently have. This can be useful when you want to buy a house or purchase your first car. These items might not be attainable with the limited cash one has. However, by engaging in a credit contract where you agree to borrow the rest of the money needed from a creditor (or lender) and agree to pay them back at some point plus some extra amount (known as interest), you can acquire the desired item. At this point, you are in debt and are responsible for paying back that money to the creditor. It is important to not overuse credit and end up violating the payment terms of the credit contract.
There are many types of credit – mortgages, automotive, student, etc. A standard example would be a first-time car buyer. Let’s say John is going to buy a blue Honda Civic for $19,000. He only had $5,000 to put down, so he will have to go to a bank to get the other $14,000 (known as a loan) needed for the car. In doing so, he is using credit to acquire an item of value now, and he will have to repay the $14,000 plus the interest (which ranges from 3-10%, so $420 to $1,400 in this case).
The information above focuses on the personal finance definition of credit. When dealing with accounting, credit has a slightly different definition we’ll discuss later.
Credit, more formally, is an agreement where a borrower receives an object or item of value and agrees to pay back the lender (or creditor) at a future time typically with interest. Interest is the additional fee or charge the lender requires the borrower to pay in exchange for using the item of value at present. As mentioned above, credit allows you to stretch from your current cash position by letting you use money or gain something you don’t have at the present.
Credit Score – How It’s Calculated
To make things more concrete and useful — practical indicator of credit involves an actual ‘score’ or your creditworthiness. This conveys how safe of a borrower you are to a lender, i.e. how consistently and quickly you are pay off the debt you are in.
This number is calculated from a variety of factors with some weighing more heavily than others. Typical factors that weigh on your credit score: payment history, credit utilization ratio, length of credit history, credit inquiries + new accounts, and type of accounts.
Payment history (~35% of score) demonstrates how consistently you can pay a loan over time. Generally, people who engage in some form of credit and pay off the loan in a timely manner have higher credit scores than someone with no credit history.
Credit utilization (~30%) is the other heavy-hitting component of your credit score. It is the ratio of your total credit card balance divided by your total credit card limit. A lower credit card utilization is typically better – it means you are more likely to be able to pay off your balance and less likely to default.
Length of credit history (~15%) of your score. The longer an individual’s credit history the more trustworthy lenders view the individual. This consists of how long certain credit accounts have been open and how frequently they are used. Type of accounts (~10%) can also cause your score to fluctuate — there are two types of credit accounts installment credit and revolving credit. Installment credit is like an auto or home loan that has fixed payments every month (typically). Revolving credit tends to be more risky as you are allowed to borrow up to a certain limit and forced to pay interest (i.e. credit cards).
Credit inquiries (~10%) can adversely affect your credit score. If a lender or landlord inquires about your credit this is recorded on your credit report. When this occurs several times, it will hurt your credit score. New accounts are trickier — while it is good to have a handful of credit accounts that are being paid regularly and not accruing too much interest, opening several in a short time span will hurt your credit. Imagine someone is short of money and they need to access credit to pay off a large new boat. They could acquire multiple credit cards and max out their credit limits on each, and then be charged significant interest on those cards quickly placing them in a tough financial situation.
Public records that contain information about filing for bankruptcy or being repossessed can negatively affect your score.
How is a credit score used?
The credit score provides a quick way for a bank or lending institution to evaluate you as a reliable borrower — if you will pay back the item of value with interest. Before you buy a house or a car, the bank will examine your credit score to assess how reliable you are with credit and will give you a lower or higher interest rate on the loan. Third party agencies such as FICO, Experian, etc. will provide approximations for a credit score. Scores typically range between 300-850, with 300 being a very poor score and a total credit risk and 850 being extremely high and no credit risk. As a lender, the higher the score for a credit applicant, the more likely you are to let the individual borrow money.