What’s Credit & How Does it Really Work?

Read Time: 4 minutes

Credit is a kind of financial magic, for many people the difference between owning or not owning a home or car. And yet, when someone asks “What is credit?” the answer is often not too clear. 

For instance, you could set aside cash to buy a first house, but for most of us that would mean a long wait because the typical home now costs more than $400,000. The result is that most buyers rely on credit to buy a home.

In 2022, for example, only 3% of all first-time buyers bought for cash, according to the National Association of Realtors. Repeat buyers – those who sold a home, likely had money from the sale, and purchased a replacement property – still used financing in 77% of their transactions.

Okay, so most of us need credit to finance our biggest purchases. But what is credit?

What is credit? A definition

If you think about “credit” you can see that it allows us to buy today and pay tomorrow. We can finance a house and repay over 30 years, buy a pick-up truck and finance for six years, or buy dinner and pay next month. Credit also involves several other features.

Know The Borrower. To have credit you must be known to the creditor – the individual or organization that says yes, we have verified certain information and believe you will repay if we advance cash for you.

Ability To Repay. If the creditor doesn’t know you personally, there must be some way to judge your ability and willingness to repay a debt. The practical way we do this today is with credit reports, credit scores, and other information.

Credit Is Limited. We can each get credit but not unlimited credit. The result is that there are maximums for such things as credit cards and mortgage loans.

Schedules Count. Creditors want to be repaid, so there are rules laying out how much is due and when. For instance, credit cards have minimum monthly payments while fixed-rate mortgages have set monthly costs for principal and interest.

Interest. Credit can have an agreed cost, but sometimes the use of credit is free. According to the Federal Reserve, the typical credit card interest rate in August 2023 was over 21%. This is a steep cost, but many credit users never pay it. How? By paying outstanding balances in full and on time each month, there are no interest costs or penalties to pay. Combine timely payments with credit cards that don’t have annual fees, and the cost of credit can be zero. 

Penalties. There are usually penalties for credit misuse such as not making payments on time or going over the credit limit. Late fees and overdraft fees add up – lenders have been taking in $12 billion a year for such charges. 

Another form of penalty is a negative comment to a credit reporting agency (CRA) such as Equifax, Experian, and TransUnion. Such negative items can reduce credit scores and that can mean steeper borrowing costs, costs that can be many times greater than a simple late fee.

There can also be serious penalties for non-payment. They can include an account freeze, cancellation, or – in the case of a car – repossession.

How Much Does A Weak Credit Score Cost?

Weak credit scores can put a hole in your wallet. Imagine that a buyer with an 810 credit score wants to finance a $400,000 mortgage. Let’s estimate that their interest rate is 6.75% versus 7.375% for someone with a 675 score.

The borrower with the better score will pay $2,594 each month over 30 years for principal and interest while the purchaser with the lower credit score pays $2,763. That’s a difference of $169 a month or a little more than $2,000 a year.

Real market pricing may differ so it pays to shop around because small rate differences can save big money over time.

Know Where You Stand With Credit

Credit is a tool that can allow you to get the goods and services you want, often well before having the cash to make such purchases. However, credit requires monitoring to ensure you’re getting the best results.

Because credit scores are based on the data contained in credit reports, it’s important to check reports from Equifax, Experian, and TransUnion. These CRAs (credit reporting agencies) are making such reports available every week and without cost at AnnualCreditReport.com.

Check the reports carefully. Look for factual errors such as a wrong name, address, or account information. If you spot a factual error, get in touch with the CRA and have it cleaned up.

Also, it’s a good idea to watch your credit score. There are various types of credit scores and you can get a score without cost on various sites, plus some bank apps show a credit score.

Check credit scores regularly. If you see big changes, look at your credit reports to see what’s happening. 

Lastly, credit scores range from 300 to 850. Within this range are bands. The average FICO credit score was 714 in 2022, according to Experian.

Credit scores between 781 and 850 will make lenders and credit card companies very happy. While you want to aim for 850, there are lower scores that can lead to strong applications and lower interest rates.

Peter G. Miller

Peter G. Miller is a nationally-syndicated columnist, the author of seven books published originally by Harper & Row (including one with a co-author), and has contributed to leading online sites and major print publications. He has appeared on numerous media outlets including the Today Show, Oprah!, CNN, and NPR.

Peter has been an accredited correspondent on Capitol Hill and a member of the White House Correspondents Association. He has served with the District of Columbia National Guard and holds both BA and MS degrees from The American University in Washington, DC. View Peter on LinkedIn.

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