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Credit 101: Understanding What Credit Is and How it Works

October 27, 2022
Mother and daughter on a laptop.

The origins of credit can be traced to the Babylonians nearly 4,000 years ago with The Code of Hammurabi, a collection of laws establishing rules for commercial interactions in Mesopotamia. Over time — from the Roman Empire to the Age of Discovery and through the Industrial Revolution — credit evolved. How we understand and use credit today dates to a century ago, with the rise of consumer credit in the 1920s, prior to the Great Depression. Now, in the Information Age, consumer credit is used to help with everything from buying a home to getting a smartphone or even a new job.

While the rules of credit continue evolving, there is no denying its importance. It’s simple: having good credit is key to obtaining buying power and it opens a lot of doors financially. With this Credit 101 guide, you will gain a firm understanding of what credit is, including its fundamentals and how it works. 

What is Credit?

Credit is what allows you to purchase items or services now but pay for them later. Credit is a financial promise, as you use it to enter a contract that requires you to pay back what you borrow — oftentimes with interest. Credit is commonly used for making large purchases, like buying a new car, and it can be used for taking out student loans or even getting a mortgage to purchase a home.

There are three types of consumer credit, which are:

Installment Credit: This is when you get a loan for a specific amount that you are required to repay. Mortgages, car and student loans fall into this category. How this type of credit works is that the lender -- typically a bank, credit union or other financial institution -- pays for a specific purchase, and you pay the lender back in installments.These payments often include interest and fees.

Revolving Credit: Credit cards typically fit into this category. With revolving credit, you are provided with a maximum borrowing limit and you must make monthly payments to pay back what you borrow to pay for purchases. If you do not pay off your balance in full each month, the difference is carried into the next month and you will likely have to pay interest.

Services Credit: This type of credit applies to when you agree to pay for a service after receiving it. From mobile phone providers to gyms and utilities, service providers have agreements with their customers, and often make you sign a contract that dictates terms and conditions for the repayment of their services.

Understanding Credit Fundamentals

A key part to understanding how credit works is knowing how your financial decisions and habits impact you. Credit unions, banks, credit card companies, and even utilities report your borrowing and repayment information to the credit bureaus, so it’s easy to trace a person’s buying habits and how they use credit.

An individual’s creditworthiness is defined one of two ways, First, it’s summarized in an individual’s credit report, which is produced by three credit bureaus: Equifax, Experian, and TransUnion. The second way to measure creditworthiness is through an individual’s credit score. A person can have good credit, bad credit or no credit, which is translated via a three-digit scoring system that scales from 300 to 850. The higher the number, the better your credit score is. According to Equifax, a score between 300 and 579 is poor; 580 to 669 is fair; 670 to 739 is good; 740 to 799 is very good; and 800 or higher is excellent. Based on how credit works, If someone has no credit that simply means they don’t have a history of borrowing money. It’s common for many young adults to fall in this category.

Understanding credit scores in detail

An individual’s credit score is based on modeling systems that break down statistical information and provide analysis, with FICO® Score being the most common modeling system. Things that can impact your credit score include:

  • Payment history, which indicates whether you pay on time, late or even miss payments
  • Your current balances
  • Number of open accounts you have and how long they have been open
  • Current loans you have
  • Whether you have had bankruptcies, car repossessions or faced foreclosure

The Importance of a Good Credit Score

If you have a good credit report and score, not only will it be easier for you to make purchases but you will be able to do so with better terms and lower interest rates. These borrowing perks can save you a lot of money, and they can open doors financially — especially when you need to make major purchases. From being able to get a mortgage with a low interest rate to taking out student loans, having good credit makes life easier in a lot of ways.

Here are some tips that are fundamental to having good credit:

  • Pay all your bills on time, making at least minimum payments so that you can avoid penalties. When possible, pay the entire amount owed to help keep your utilization down. When you have low utilization (under 30% is recommended) your credit score will be rewarded
  • Keep your accounts open. Part of analyzing your credit history is how long your accounts have been open, so it’s good to keep credit cards open — even if you don’t use old credit cards often anymore
  • Don’t open too many lines of credit too fast. A good rule of thumb is to wait a minimum of six months between credit applications, when possible
  • Sign up for a credit monitoring to help you keep track of your credit report and score

If you are someone who has no credit but would like to begin building it, a great way to get started is to take out a credit-builder loan. These are loans where DCU, or another issuing credit union or bank, holds onto your money until the full amount is repaid, and then they release funds back to you. For this purpose, DCU offers secured credit cards. These cards, which have all the same benefits as our Visa Platinum credit card, allows members to borrow against their DCU savings account.

Take Control of Your Credit with DCU

Ultimately, a credit report and score is reflective of how you have handled debt in the past. If you are responsible with your debt over an extended period, you will be rewarded with good credit which leads to more buying power and opportunities for saving.

Whether you need a car loan or want a new credit card, let Digital Federal Credit Union help. Our not-for-profit credit union can save you money on your next loan, and with our Visa cards you get low interest rates and great terms. Become a member and you can even get your monthly FICO® Score to help you monitor your credit.

Please note, membership is required to open a DCU Auto. Visit our membership eligibility page for more information.

This article is for informational purposes only. It is not intended to serve as legal, financial, investment or tax advice or indicate that a specific DCU product or service is right for you. For specific advice about your unique circumstances, you may wish to consult a financial professional.