Learning How Credit Works Puts You in Control

Is credit bad?

Credit is not inherently a bad thing or something to be afraid of. Like a car loan, a mortgage, or even cash, credit is simply a financial tool. Using it irresponsibly can result in problems, but using it wisely can help you save money and build wealth. 

Credit has other benefits, too. Strategic credit use can help you:

• Make purchases or pay bills if your paycheck arrives after those due dates
• Keep cash in your accounts (great for emergencies)
• Protect yourself against fraud and theft (since it’s not your “real” money that was used)
• Save time and effort – there’s no need to write checks or keep cash on hand, especially for large purchases

Avoiding credit can actually end up hurting you in the long run. As a country built on credit, not having any can make it extremely difficult to purchase a vehicle, find a place to rent, start a business, or sometimes, even get a job. Money might make the world go round but credit is what holds it together and is a necessity for all Americans.

When used correctly, credit cards can be a useful tool and a vital part of your financial strategy. They only cause problems when you don’t have a plan in place to manage the debt OR when you use them to cover expenses you can’t afford. Setting some ground rules can help you avoid the financial challenges that credit cards cause.

These resources can help you gain a better understanding of how to use credit and manage credit card debt so you always maintain control over your finances:

• How to use credit cards the right way
• How to read and use your credit card statements
• Credit card debt statistics: How do you stack up?
• How much credit card debt is too much?
• Learn smart ways to reduce credit card debt
• 10 warnings for consolidating credit card debt
• Learn to negotiate effectively with your creditors
• 5 ways to recognize a credit card debt problem
• Credit card debt quiz: Is it time to get some help?
• College students and credit cards: A guide to using credit on campus

How do you build credit?

Getting credit is like getting money – it’s easier to acquire more if you already have it. First and foremost, lenders need to be convinced that you can repay what you borrow. They’ll examine your income and how much you already owe to others. Even high earners can be denied credit if they have a high debt load. 

However, lenders also want to know that you’re trustworthy and won’t skip out on the debt. They’re not going to take your word for it. Instead, they’re going to look at your credit report, a comprehensive file with details like…

• Every credit card or loan you have held (and every application you’ve ever sent trying to get one)
• How often you’ve maxed out your card
• Any time you’ve been late or missed a bill payment

This is why it can be tricky to get credit if you don’t already have any – but it’s not impossible. Common ways to build credit include: 

• Federal student loans. Acquired by filling out FAFSA, these are based on need and have no credit score requirements. 
• Secured credit cards. Works like a standard credit card but the borrower must provide cash as collateral in order to access the credit.
• Credit-builder loans. A niche type of loan taken out solely for the purpose of building up a person’s payment history. 
• Become an authorized credit card user. A primary card holder can add someone to their credit card account. This person isn’t liable for making payments but card activity is reported to all users’ credit reports.

These methods can also be used to repair damaged credit, though there are additional actions one would likely take, such as disputing incorrect or harmful credit comments. If you find something unfamiliar in your credit report, you can file a dispute to correct whatever is wrong. This won’t have any impact on credit score – learn more about the process here. 

Credit report vs. Credit score

A credit report is a statement that contains all past and present credit activity. This information is provided by banks, credit card companies, landlords, and even the courts to credit bureaus, who compile the information. The main credit bureaus are Equifax, Experian, and TransUnion.

Using data from a credit report, each credit bureau calculates on a scale of 300-850, and that number becomes a person’s credit score. Credit score can heavily influence interest rates and borrowing terms.

Not all credit bureaus have all the same information as some lenders only report to some bureaus and not others. It’s also fairly common for bureaus to make mistakes – about one in five credit reports have. To check for errors, a person can receive a free copy of their credit report from each credit bureau once every week from AnnualCreditReport.com.

Types of credit

There are three common types of credit: revolving, installment, and open credit. 

A revolving line of credit means there’s a maximum amount you can borrow (known as a credit limit) and can repeatedly borrow up to as long as your account is open. For example, say you have a credit limit of $10,000. If you spent $2,000 on the card, you’d still have $8,000 available to borrow. Once you repay that $2,000, you’ll have the full $10,000 available again. 

Revolving credit is the type you’re most likely familiar with since it’s the most commonly used form of credit – you guessed it, credit cards. Another type of revolving credit is a HELOC (home equity line of credit) which works like a credit card, but the amount you can borrow is based on the value of your home. 

Next is installment credit, a fixed borrowed amount typically dispersed in a lump sum and repaid in the same amount each month (known as installments). Types of installment credit include loans such as student loans, auto loans, mortgage loans, and home equity loans, etc. Installment credit is different from revolving credit in that paying down the balance does not increase the amount that can be borrowed, and repayment is broken up into amounts that are the same every month.

Finally, there is open credit. Sometimes mixed up with revolving credit, open credit is unique in that there is usually no set limit on how much can be borrowed, but that entire balance must be paid once it becomes due. The most common type of open credit are charge cards. They appear and function identically to credit cards, but charge cards usually don’t have preset credit limits and users aren’t able to carry a balance. They are also a lot less commonly used than credit cards.

Credit can also be further broken down by how the credit limit is derived. There’s secured credit, which refers to any type of credit that’s backed by collateral – a financial asset like a piece of property, a vehicle, or even cash counts. The amount of credit given is usually directly correlated to the value of this collateral and should you default, that asset would be taken as payment. Credit issued without collateral is known as unsecured credit. Lenders determine lending limits based on things like your credit score, credit history, and income. 

Basic credit terms and definitions

APR (annual percentage rate): The privilege of borrowing money comes at a cost, usually a percentage of the total amount borrowed. Often used interchangeably with the term ‘interest rate’ or ‘interest’, this number represents how much the balance would increase over a year if a balance were held. For example: a carried balance with a 22% APR would increase by approximately 22% over a year. 

Balance: The total amount owed on a line of credit, does not necessarily reflect what is expected in an upcoming monthly payment.

Billing cycle/billing period/statement period: The number of days between credit card statements; typically 30 days.

Closing date: Marks the end of the current billing cycle. Purchases made before the closing date will be included in the upcoming monthly statement (i.e. the bill); those made after the closing date will be included in the following month’s statement. 

Credit card statement: A summary document given at the end of a billing cycle that details all cardholder information including transactions, total balance, interest, and other charges. 

Credit limit: The maximum amount of money that can be borrowed by the account holder.

Minimum payment: The lowest amount you can pay while remaining in good standing with a lender. 

Statement balance: The amount of money owed in the upcoming payment. Can differ from the total balance, depending on whether purchases were made before or after the closing date. 

Term: The length of time available to repay a loan; does not apply to credit cards. Often listed in years or the number of payments.

Transactions: Purchases made using a credit or charge card.

How does credit card debt work?

Credit cards are the biggest source of consumer debt, second only to mortgages, and are the type of debt most likely to get borrowers into trouble – for a number of reasons. 

Carrying a balance

The number one mistake people make with credit cards is carrying a balance. Carrying a balance means paying interest. Those interest fees end up being tacked onto the original balance, creating a new higher balance that means even higher interest charges the following month, so on and so forth. If you’re only making minimum payments, most of your money goes towards interest payments rather than the principal balance, making it nearly impossible to get out of credit card debt.

Credit card fees

Another common cause of credit card debt is not understanding credit card fees. Like any other business, credit card companies need to make money. One of the ways they do this is through a variety of fees. Late fees are common, but you should also keep an eye out for high annual fees, balance transfer fees, and more.

Discover how fees work and how to avoid them »

High interest rates

By extension, another big problem with plastic is high annual percentage rates. Credit cards have a much higher APR compared to other types of credit, like mortgage or auto loans. Average interest rates are upwards of 20% (mortgage rates, by comparison, average around 6-7%), making credit card debt the most expensive kind to have. If making minimum credit card payments, nearly two-thirds of every payment gets eaten up by interest charges.

This table shows you the total interest charges you can expect to pay on a $5,000 credit card balance if you make minimum payments. 

APR	Total Interest Charges
15%	$4,636.99
17%	$6,045.56
19%	$7,958.04
21%	$10,707.60
23%	$15,006.98

Read about how minimum payments really work »

Know your rights as a credit user

The final piece of good credit management is understanding how your rights as a consumer are protected under federal law. There are key consumer protection rights that help prevent predatory lending and other unfair lending practices, collector harassment, and credit abuse. Knowing what these laws say can help ensure that every creditor, collector, or financial professional you work with is doing what they should be doing to help you.

Get detailed instructions on repairing your credit »