Credit is so much more than just a piece of plastic.
Credit is a way to borrow money or access goods and services now with an agreement to repay what you owe under specific terms. Depending on the type of credit, those terms may include an interest rate, fees, a repayment schedule, or a credit limit.
Understanding how credit works can help you make informed borrowing decisions and manage debt responsibly. How you use credit can also become part of your credit history, which lenders may consider when deciding whether to extend credit and what terms to offer you.
Key Takeaways
Credit lets you borrow money or make purchases now and repay what you owe under agreed-upon terms.
Revolving credit can be used repeatedly up to a credit limit, while installment credit is repaid over a set period.
Secured credit cards, credit-builder loans, and authorized-user accounts can help establish a credit history.
Credit reports contain information about your credit history, while credit scores are calculated using information from those reports.
Carrying credit card debt can get expensive. Interest adds to what you owe, and making only minimum payments can keep you in debt much longer.
What is credit?
Credit is an agreement that allows you to borrow money with the promise that you’ll repay it later. Banks, credit unions, credit card issuers, and other financial institutions can extend credit through products such as credit cards, personal loans, auto loans, and mortgages.
Think about paying for a restaurant meal with a credit card. The restaurant gets paid, but the money for the purchase doesn’t come directly from your checking account. Your credit card issuer covers the transaction, and you then owe the issuer for that purchase under the terms of your credit card agreement.
The word “credit” can also refer to your history as a borrower and how lenders evaluate you for new credit. Your credit history can influence whether a lender approves an application, how much you can borrow, and the interest rate or other terms you may be offered.
If you’re struggling with your credit cards and need help, you can use our Virtual Intelligent Counselor. It’s free, takes only a few minutes, and you can save time before speaking with a counselor.
How does credit work step by step?
Although different types of credit work differently, the basic process usually looks like this:
You apply for credit. A lender reviews information used to determine whether you qualify.
The lender sets the terms. Depending on the account, these can include how much you can borrow, the interest rate, fees, and how repayment works.
You borrow or use the credit. This might mean making purchases with a credit card or receiving money through a loan.
You repay what you owe. Your agreement determines when payments are due and whether interest or fees apply.
Your account activity may be reported to the credit bureaus. Lenders don’t necessarily report every account or activity to every credit bureau.
Your credit history can affect future borrowing. Information in your credit reports may be used in credit-scoring models and by lenders when evaluating future applications.
Is credit good or bad?
Credit itself isn’t inherently good or bad. It’s a financial tool, and whether it helps or hurts your finances depends largely on how you use it. Borrowing too much can make debt difficult to manage. Interest and fees can make it even harder to pay off.
Access to credit can be useful in several ways. It may help you:
Finance major purchases such as a home or vehicle without paying the entire cost upfront.
Build a credit history that lenders may consider when you apply for credit in the future.
Handle an unexpected expense when you don’t have enough savings available, although borrowing means taking on debt that must be repaid.
Take advantage of certain credit card protections, which can provide additional safeguards when making purchases.
Manage cash flow by giving you time between making a purchase and paying your credit card bill, particularly if you pay the statement balance in full by the due date.
The key is to have a repayment plan in place before you borrow. Credit cards, in particular, can become expensive when you regularly carry balances because interest and fees can increase the amount you ultimately repay.
Credit cards can be a helpful tool and a vital part of your financial strategy when used correctly. They only cause problems when you don’t have a plan to manage the debt OR use them to cover expenses you can’t afford. Setting some ground rules can help you avoid the financial challenges that credit cards cause.
[On-screen text] Are credit cards good or bad?
Gary Herman, President of Consolidated Credit: I happen to love credit cards and not just because I’m in the business of helping people pay off credit cards. There are a lot of very smart ways that people use credit cards – not just for convenience, but also to save money. I would love to see people solve their debt-related and learn really smart ways to use credit cards.
Credit cards often offer multiple points for things like groceries or gas. Some people just use a gas card at the gas station and they save 3-5% on their purchases. Instead of having interest go to the banks, now you’re the one earning a percentage off of every charge.
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How do you build credit?
Building credit takes time. Lenders want to see how you have handled credit in the past before deciding whether to extend new credit. That does create a challenge when you’re just starting out: How do you build a credit history when you don’t have any credit yet?
There are several ways to get started:
Open a secured credit card. You provide a refundable security deposit, which typically helps determine your credit limit. Using the card and paying on time can help establish a payment history if the issuer reports the account to the credit bureaus.
Consider a credit-builder loan. These loans are designed to help people establish credit. The money you borrow is typically held in an account while you make payments and released after you’ve repaid the loan.
Become an authorized user. Someone may be able to add you to an existing credit card account. If the issuer reports authorized-user activity to the credit bureaus, information from that account may appear on your credit reports.
Once you have credit, how you manage it matters. Paying bills on time and keeping accounts in good standing can help you establish a positive credit history.
Check your credit reports for errors
It’s a good idea to review all three credit reports because the information in them may differ. Look for accounts you don’t recognize, incorrect balances or payment information, and other mistakes.
Credit report errors aren’t uncommon. In a 2024 Consumer Reports study, 44% of people who checked their credit reports found at least one error.
If you find inaccurate information, you can dispute it with the credit reporting company. You can also contact the company that provided the incorrect information.
You can check your credit reports from Equifax, Experian, and TransUnion online for free every week through AnnualCreditReport.com.
What are the different types of credit?
Credit generally falls into two main categories: revolving credit and installment credit. Credit can also be secured or unsecured, depending on whether the debt is backed by collateral.
Revolving credit
Revolving credit gives you a credit limit that you can borrow against repeatedly as long as the account remains open.
For example, if you have a credit card with a $10,000 limit and charge $2,000, you have $8,000 in available credit remaining. As you repay the balance, that credit becomes available to use again.
Credit cards are the most common example of revolving credit. A home equity line of credit (HELOC) is another. With a HELOC, you borrow against the equity in your home.
Installment credit
Installment credit involves borrowing a set amount of money and repaying it over a specified period. Payments are made according to a schedule established when you take out the loan.
Mortgages, auto loans, personal loans, and student loans are common examples.
Unlike revolving credit, paying down an installment loan doesn’t restore that amount for you to borrow again. Once the loan is repaid, the account is typically closed.
Secured vs. unsecured credit
Secured credit is backed by collateral. Mortgages and auto loans are common examples. Your home secures a mortgage, while your vehicle secures an auto loan. Secured credit cards use a cash deposit as collateral.
Unsecured credit isn’t backed by collateral. Credit cards and many personal loans are common examples. Lenders consider factors such as your credit history, income, and existing debts when deciding whether to approve an application and what terms to offer.
Basic credit terms and definitions
Understanding a few basic terms can make it easier to compare credit products and understand what you owe.
APR: Annual percentage rate. For credit cards, the APR represents the annualized interest rate charged on balances subject to interest. A credit card may have different APRs for purchases, balance transfers, and cash advances.
Balance: The amount you currently owe on an account.
Billing cycle: The period covered by a credit card statement. At the end of each billing cycle, the card issuer generates a statement showing your account activity.
Closing date: The last day of a credit card’s billing cycle. Transactions made after the closing date generally appear on the next statement.
Credit card statement: A summary of your account for a billing cycle. It includes transactions, payments, your balance, minimum payment, payment due date, interest charges, and fees.
Credit limit: The maximum amount of credit the issuer has made available on the account.
Minimum payment: The smallest amount you must pay by the due date to keep the account current. Paying only the minimum can significantly increase the time it takes to repay a balance and the amount of interest you pay.
Statement balance: The amount you owed at the end of the billing cycle. This is different from your current balance, which can change as you make new purchases or payments.
Term: The length of time scheduled for repayment of an installment loan, such as 36 months for an auto loan or 30 years for a mortgage.
Transaction: Activity on an account, such as a purchase, payment, balance transfer, cash advance, fee, or credit.
How does credit card debt work?
Credit cards are a type of revolving credit. You can make purchases up to your available credit limit and repay what you borrow over time.
Each purchase adds to your balance. Payments reduce it and make more of your credit available again. If you carry a balance from one billing cycle to the next, you may be charged interest based on your card’s terms.
Your credit card issuer requires you to make at least a minimum payment each month when you have a balance. Paying only the minimum keeps you in debt longer and can substantially increase the amount of interest you pay.
Paying more than the minimum reduces your balance faster. If you can pay your statement balance in full by the due date, you can generally avoid interest on new purchases when your card has a grace period.
The world of credit doesn’t have to be so confusing. Here’s a simple 60-second explanation of how credit card debt works.
Credit card debt is revolving. This means the more debt you put in by making charges, the higher your bills are coming out the other side. So, the amount you owe each month changes based on how much you charge.
Each payment you make is split into two parts: Paying off interest added and paying off actual debt. If you only make the minimum payments required, the bulk of each payment made goes to interest. As a result, it takes a long time to pay off your debt and credit card purchases can end up costing double or triple the purchase price with interest added. Plus, if you rely too much on credit, your payments can get so big that you don’t have enough money to cover all the expenses in your budget.
If you want to be financially successful, you have to keep credit card debt minimized. We can help. Call Consolidated Credit today for a free debt analysis with a certified credit counselor.
What makes credit card debt expensive?
Credit card debt can become expensive when you carry a balance from month to month. Interest and fees can add to what you owe, while making only minimum payments can stretch repayment over a much longer period.
Carrying a balance
If your credit card has a grace period, you can generally avoid interest on new purchases by paying your statement balance in full by the due date.
If you carry a balance, interest may be charged according to your card’s terms. The longer you carry that balance, the more interest you can pay.
Minimum payments are designed to keep your account current, not to pay off debt quickly. Paying more than the minimum reduces your balance faster and generally reduces the total interest you pay.
Credit card fees
Interest isn’t the only cost that can come with using a credit card. Depending on the card and how you use it, you may encounter fees for:
Late payments
Balance transfers
Cash advances
Foreign transactions
Annual membership
Before opening a credit card, review its rates and fees so you understand what the card may cost to use.
Credit card APR determines the interest rate applied to balances that are subject to interest. The higher the APR, the more expensive it can be to carry the same balance.
Even a few percentage points can make a meaningful difference when you carry debt for a long time. The next example shows how APR can affect the cost of paying off a $5,000 credit card balance.
APR
Total Interest Charges
15%
$4,636.99
17%
$6,045.56
19%
$7,958.04
21%
$10,707.60
23%
$15,006.98
What rights do you have when using credit?
Federal laws give you certain rights when you apply for credit, use credit cards, review your credit reports, or deal with debt collectors.
Some important protections include:
Credit reporting: You have the right to dispute information on your credit reports that you believe is inaccurate or incomplete. Credit reporting companies generally must investigate qualifying disputes at no cost to you.
Credit disclosures: Lenders must provide certain information about the costs and terms of consumer credit. Depending on the type of credit, this can include the APR, finance charges, payment information, and other terms.
Credit card billing errors: You have the right to dispute certain errors on your credit card bill. Federal protections establish specific procedures and deadlines for billing disputes.
Debt collection: Federal law prohibits debt collectors from using abusive, unfair, or deceptive practices when collecting certain consumer debts.
Understanding these rights can help you spot problems and take action when something isn’t right.
Learn more about using credit wisely
These resources can help you learn more about using credit, understanding credit card debt, and managing debt when it becomes difficult.
Credit lets you borrow money with an agreement to repay it under specific terms. Depending on the type of credit, those terms may include an interest rate, fees, a credit limit, and a repayment schedule. How you manage credit can also become part of your credit history.
How do you build credit if you don’t have any?
You can start building a credit history with products designed for people with limited or no credit, such as a secured credit card or credit-builder loan. Becoming an authorized user on someone else’s credit card may also help establish credit history if the issuer reports authorized-user activity to the credit bureaus.
What’s the difference between a credit report and a credit score?
A credit report contains information about your credit accounts and payment history. A credit score is calculated using information from a credit report. You can have multiple credit reports and multiple credit scores.
What are the main types of credit?
The two main types are revolving and installment credit. Revolving credit, such as a credit card, can be used repeatedly up to a credit limit. Installment credit, such as a mortgage or auto loan, provides a set amount that you repay over a specified period.
Does using credit mean you’re in debt?
When you use credit to borrow money or make a purchase, you owe that amount until you repay it. That doesn’t necessarily mean you have a debt problem. The important distinction is whether you can manage what you owe and repay it according to the account’s terms.
What happens if you only make the minimum payment on a credit card?
Making the minimum payment generally keeps your account current, but it can take much longer to pay off the balance. If you’re being charged interest, paying only the minimum can also significantly increase the total amount you pay.
