Money·9 min read

Credit 101: How Credit Works and 29 Terms You Need to Know

Woman holding phone and credit card
Design: theSkimm | Photo: iStock
Nov 10, 2022

Credit can make your life easier. Swiping (or tapping) is a convenient way to pay for groceries, gas, and Sephora hauls. And loans can help you stretch out big, important purchases (like a car or home) over time. But things can get out of hand quickly if you aren’t careful. Which is why we’re Skimming all things credit: how it works, why it’s so important, and the lingo you need to know.

Let’s start with the basics: What is credit?

It’s how you can pay later for the stuff you need (or want) now. Credit can come from a lot of different sources, depending on the situation. Here’s a breakdown of the three main types: 

Installment credit

This means you’re borrowing one lump sum and paying it back a little at a time on a schedule, aka in installments, with interest. Mortgages, auto loans, and student loans all fall into this category. 

Revolving credit

This means you can borrow as much as you need, whenever you want, until you hit the limit you were given. You pay this back a little at a time, but not on a set schedule. And interest gets added to the balance you owe at the end of your statement. Which means paying early or on time can help you avoid interest. Think: credit cards and lines of credit. 

Open credit

With open credit, how much you pay can change with each statement, but you’re expected to pay what you owe at the end of your billing cycle. Utility bills, like electricity, cable, and water, are all examples of open credit accounts. 

How does credit work?

When you promise to buy now and pay later, it gets reported to three credit bureaus: TransUnion, Experian, and Equifax. And it becomes a part of your credit history. The credit bureaus give you a FICO and VantageScore based on how your credit history is going, aka your credit score. VantageScore and FICO scores are pretty similar overall, but the math isn’t exactly the same. Hint: FICO scores give more weight to how long your credit history is, and VantageScores focus more on how much you owe.

The better you are at making your payments on time, the higher your credit score. And a higher score = more likely a lender will let you borrow money. Think: 800 to 850 range. A lower score, typically between 300 and 579, makes lenders think twice about giving up money. 

View post on Instagram
 

I think I know the answer, but why is credit important?

Credit can help put you on the path to financial freedom and generational wealth. Because it gives you access to things you need, but don’t have enough cash to buy. Including the big, wealth-building things. Think: A new home or business loan. Without a good credit history, even if you get approved to pay later, you’ll have to pay more. Because a shaky credit score means higher interest rates (or possible denial). 

Got it. Any pointers on how to build credit? 

Throw on some LunchMoney Lewis and start paying those bills. On time. Because a good payment history is the key to getting a good credit score. But that isn’t the only factor: Credit bureaus look at how much you owe, how long you’ve been using credit, and the variety of credit types you use. (Psst...Remember the types of credit we talked about earlier?)

Pro tip: Check your credit reports each year. It's free. And just like everything else in life, mistakes happen. But in this case, they could impact your credit score. Whether it's a simple error (like a misspelled address) or identity theft. If you spot a mistake, here's how to report it. Heads up that you can check your report more than once a year, but you might need to pay up.

View post on Instagram
 

Any special credit terms I should know? 

Learning the language is a great way to understand the ins and outs of credit. So we Skimm’d some of the major ones you should know:

APR: Annual percentage rate. It’s what you’re charged for borrowing money. Like for a credit card or mortgage. Play it like golf: aim low.

Balance transfer: When you shift your debt from one card to another, usually to get a lower interest rate. Maybe even no interest rate. But there are some rules, so read the fine print.

Bankruptcy: When you go to court to legally divorce your debt. It’s not always a clean break: the details can stay on your credit report for up to 10 years. And you could have to sell your home or car to pay back your lenders.

Cash advance: When your debit and credit cards pull a “Freaky Friday,” and you use your credit card to pull cash out of an ATM. But this withdrawal has to be paid back...and then some. With interest and fees.

Charge-off: The one where your lender starts to develop trust issues, gives up on chasing you down for payments and reports your debt as a loss. This does not look good on your credit report.

Charge card: Not a regular card, but a cool card. The kind without a spending limit or interest rate. Because you have to pay your balance in full…every single month. Good for people who like rewards and have a great credit score.

Collections: A place you don’t want to go. After not making a debt payment for a certain amount of time, your lender may ask another agency to step in and make you pay. Go-to tactics include calling a lot and mailing ‘pay now’ letters.

Compound interest: Interest that’s added to money that’s already gained interest. It keeps your balance growing and growing. Your best friend when you’re saving and investing…and your worst enemy when you’re racking up debt.

Credit bureau: A company that keeps track of your credit history, translates it into your credit score and credit report, then sells it to banks and lenders. 

Credit freeze: When you put your credit on ice to block new lenders from seeing your credit report. Making it harder for identity thieves to open an account in your name. Cold, but safe.

Credit limit: How much you can spend before you max out your credit card or loan. Based on things like your income, how much debt you already have, and your track record with credit.

Credit report: Basically your resume for landing a loan. It includes info like how much debt you have, if you’ve ever filed for bankruptcy, and whether you pay your bills on time.

Credit score: An important number that helps banks and credit unions decide whether you’re good lending material. And how much interest they’ll charge you. The higher credit score, the better.

Credit utilization ratio: The sum of your balances compared to the sum of your credit limits. Psst...lenders like it when you go low.

Delinquency: The penalty box for borrowers who are late on a debt payment. Lenders may punish you with extra fees. And the evidence can stay on the record for years.

Fair Credit Reporting Act: A federal law that gives credit bureaus some important ground rules, like keeping your personal info private and telling the truth about your credit history.

FICO: The popular kid of credit scores. Aka what lenders look at to determine whether you’re likely to ghost them on payments. Ranges from 300 to 850. Anything above 750 is star status.

Fraud alert: A red flag you can wave when you think something shady (*cough* identity theft) may be going on. It tells lenders looking at your credit report to go the extra mile to verify you are who you say you are before approving new credit.

Hard inquiry: Aka a “hard pull.” This happens when you apply for a loan or a new line of credit. Try not to overdo it. Too many hard pulls can hurt your credit score.

Lender: A person, bank, credit union or other financial institution you borrow money from...with strings attached. In the form of interest and fees.

Minimum payment: The least you can get away with paying on your credit card or loan each month without getting a late fee.

Penalty APR: A higher interest rate your lender can charge you for doing something bad. Like paying late or spending over your credit limit. Nice lenders usually let you get back to your regularly scheduled rate after you pay on time for six months.

Prepaid credit card: A card you preload with money. So you’re not actually borrowing, but spending money you already have. Like a gift card you can use (almost) anywhere.

Revolving credit: Any accounts you can keep borrowing from — then repaying — over and over. Like credit cards and home equity lines of credit. 

Rewards card: A fan-fav credit card that gives you a little something extra (like cash back or airline miles) when you use it.

Secured credit card: Looks like a regular credit card and acts like a regular credit card. But requires a cash security deposit, unlike a regular credit card. Typically for people who’ve had a rocky relationship with credit in the past.

Settlement: An agreement that you’ll pay a percentage of your debt because you can’t afford to pay it all. Not ideal. But it helps avoid bankruptcy, which hurts your credit score even more.

Soft inquiry: A credit check that won’t hurt your credit score and isn’t connected to an application for new credit. Think: background checks or credit card pre-approvals.

VantageScore: Basically FICO’s younger brother. It’s another credit scoring model that grades you from 300-850 but isn’t as widely used by lenders.

theSkimm

Credit can be a huge help (or obstacle) when it comes to crushing your money goals and building wealth over time. Want to make sure you’re on the right path to a high score? Start with paying your bills on time and learning the language. 

Updated on Nov. 10 to reflect new information.

Subscribe to Skimm Money

Your source for the biggest financial headlines and trends, and how they affect your wallet.

fbtwitteremail