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What Is Credit and Why Is It Important?

A financial transaction is an agreement or communication carried out between a buyer and a seller to exchange an asset or payment. Credit is the same thing, except instead of 'asset or payment,' we say the 'promise of payment.'

Credit is a central force in our financial lives. It shapes our purchasing decisions and our ability to buy shelter, purchase cars, vacations, and fund businesses. It even impacts our ability to qualify for employment.

Unless you have access to large sums of cash, credit is necessary to meet your financial goals. This page will cover the different types of credit, why it is crucial, and the importance of your credit score.

Types of Credit

When used responsibly, credit can be a powerful tool to meet your financial goals. As society continues to transition away from cash, focusing on convenience, more ways of borrowing money are increasingly emerging.

Here are four ways to borrow money along with the advantages and disadvantages of each

Revolving credit

One of the more common forms of credit, revolving credit, enables you to borrow money up to a certain amount. The lender sets a credit limit based on your credit score, and revolve the balance every month until paid.

As you pay back the money borrowed, interest charges are incurred. Every month, the difference between the maximum credit limit and your current balance is available for use. Most credit card companies like Mastercard and Visa issue revolving credit.

Charge cards

Unlike revolving credit, a charge card cannot carry a balance as it must be paid in full every month. If not paid off on time at the end of the month, penalty fees are added. A benefit of charge cards is their convenience, and they don't accumulate credit card debt. American Express is known primarily for charge cards.

Service credit

Service credit loans enable a borrower to pay for a membership or service at a later date. These are also known as non-installment loans. Most often, the payment is due the month following service. Unpaid balances may incur interest, a fee, and other interest charges.

If not paid, the service is canceled. Examples of service credit include utility bills such as your cell phone, electricity, gas, and your water bill.

Installment credit

With an installment loan, the lender loans a set amount of money and gives you a timeframe for when the amount borrowed must be paid back. Interest is pre-determined and integrated into the monthly payment. Auto and mortgage loans, in addition to personal loans, are a form of installment credit.

Unsecured and Secured credit

All credit falls into two categories; unsecured and secured. Unsecured credit is a loan that is not attached to an asset or collateral. Most credit cards and charge cards are in the form of unsecured credit. In contrast, secured credit is attached to an asset or collateral such as an automobile or home.

Why do you need credit?

Buying a home or driving a nice car is a goal that many people have. However, they often don't have access to the large sum of cash needed to buy one. As a result, they need credit to access the asset. Credit is a 'promise to pay.' However, this promise is conditional on the borrower agreeing to specific terms and conditions such as the timeframe for the loan, interest, and other factors.

How to determine your credit score?

When someone asks about your credit, they are most likely referring to the information contained in your credit report. Your credit report calculates your credit score based on the amount of money you have borrowed, the types of credit you have taken out, and how you paid back these debts.

Credit reporting agencies look at this information to predict the likelihood that you will pay back the money you seek to borrow. Your credit history will determine whether you get the loan and the interest rate charged to access the funds.

Your credit score does not only factor in your ability to borrow money. When you look to rent an apartment, buy insurance, or apply for a job, your credit score may also be taken into consideration.

What is a good credit score?

Your credit score defines your ability to borrow money. The more responsible you have been in managing credit in the past, the more credit you can access.

Credit scores range from 300 to 850. A good credit score is usually in the range of 650 to 719. The higher the score, the easier it is to be approved for a loan or credit card, and the lower the interest you will payback.

Where there can be a lot to know about increasing and managing your credit, there is guidance available that others have used. It has helped them secure lower interest rates on loans for the things that make up their financial goals.