Infographic: What is Credit and How Does Credit Work? | Refresh Financial

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Infographic: What is Credit?

What is Credit and How Does Credit Work?

What is credit?

Credit. We’ve all heard the word used, and used it ourselves. You might have a little credit yourself. Everyone you know likely has it in some way or another; even everyone you don’t know. Most people use credit to buy their first car or home. Many of us credit to book flights and hotel stays. Some of us even use credit to buy our everyday needs. We are all surrounded by credit in its many different forms, but do we all understand what it really is and how your credit works?

What is credit?

The easy answer, of course, is that credit is just money that you borrow. That’s it. You ask to borrow money, and someone who has the dough either says, “sure” or “no way!”. This is the simplest way to look at the word, but this doesn’t even scrape the surface of what credit really means.

How is credit used?

Today, credit can be used in a few different ways.

  • The first way we use the word credit is to refer to an agreement or a contract between a lender and a borrower. The lender agrees to front a chunk of money to the borrower. In turn, the borrower agrees to pay the amount of money, plus a fee, back within a certain amount of time. This is like a credit card, or a loan, or maybe even just asking your buddy for ten dollars when he expects it back with interest.
  • Another way we use the word credit is to refer to an addition to your account. For example, when you are paid by your employer, the money is deposited into your bank account: this is a credit. The opposite of this is a debit, when money is taken out of your account.
  • Finally, credit can also mean a person’s or a business’ ability to borrow. You’ve heard it used this way before: “He has great credit”. This means that “he” should have no trouble borrowing money from a company that lends it. This ability to borrow money is usually based on your reputation as a borrower, a reputation that is represented by a number, kind of like movie ratings. The higher the rating, the better you can expect the movie to be. It’s the same with your borrowing reputation. The higher your number is (we call it a credit score) the more likely a lender is to lend you some cash. You can have good or bad credit, so-so credit, or none at all.

What does it mean to have “good credit” or “bad credit”?

Your credit score should show whether you stick to your word when you agree to pay back money you’ve borrowed. Do you pay it back? Do you do it on time without having to be reminded? Have you ever missed a payment or two, or found yourself unable to pay back the money you borrowed?

  • Credit bureaus keep track of your lending history and if you make all your payments on time, and pay back the money you borrow when you’re supposed to, you will end up with a good score, or “good credit”. In the future, when you apply to borrow money, the lender will see that you pay your debts and will likely keep doing so. This makes you a lower risk to the lender – lending to you means they will most likely be paid back, in full, with the fees and without the need to hire a company to collect what they are owed. You’re a good bet.
  • However, if you’ve been known to forget payments or just skip them altogether and you already owe a lot of lenders money, you will have “bad credit”. This makes you a very high risk, and lenders will likely turn down any requests you have to borrow money in the future.
  • People who have no borrowing history will have no credit. These can be young adults just starting out, or it can be people who have never had the need to borrow, and have never had any regular payments in their name.

Companies that are thinking about lending money to you can take a peek at your credit score and use it to decide whether or not to lend you the money. Your report lists your lending history including loans, credit cards, lines of credit, leases, etc. Basically any money you’ve ever been on the hook for before. The report includes information on your payment habits, what money you may still owe, who you have paid back already, and what you may have not paid back on time.

What is my credit score?

Your credit score is a number value used to represent everything on your credit report. It is the result of a computer program set up to review what is on your report and convert all that information into a score between 300 and 900. The higher your score is, the less risk someone is taking if they lend you money.

When lenders judge your risk factor after you have applied to borrow money from them, they don’t often look at your credit report. Instead, they just look at your credit score. This number is usually enough to tell them whether or not they should lend to you.

In Canada, you can request your credit report for free as many times as you like, so long as you submit your request in writing. This is different from the USA, where consumers are only entitled to one free credit report, not including their score, per year.

Both your credit score and report are kept track of by credit bureaus. These bureaus are agencies that collect all the information contained in your credit report and give you a score based on that information. Credit bureaus are also where you go when you want a copy of your own credit report, or if you are considering lending money to someone and want to see if you’re taking a risk in doing so. The two bureaus that operate nationwide in Canada are Equifax and TransUnion. If you want a complete idea of what your score  looks like, it is best to request your credit report from both bureaus.

What is on my credit report?

When you see your own  report, you’ll probably be surprised at how much information is there. Going back six to seven years, all the credit decisions you’ve made will be listed. You’ll see your payment habits, the total money you owe and have borrowed, who you owe it to, and what your limits are on each form of credit you currently have. There may also be surprises too, which is why it’s good practice to check your report every so often. There can be errors or the records of someone else who is using your identity to borrow money. Your personal information can be listed wrong, and your financial information can be incorrect. You should double check at least once per year to make sure that everything listed in your credit report is correct and up-to-date.

Your credit report and score are not always just used to weigh how risky it is to lend to you. They can also be used as additional information for employers when they’re considering whether or not to give you a job. The idea here is that someone with a great score is someone who takes their responsibilities seriously; someone you can rely on and trust and who would be a great employee. On the other hand, a person who has not always done the best job paying back the money they owe, may not be someone that can be relied on in a work setting.

Why do people get into credit trouble?

Of course, in real life, things are not always this simple and there can be many reasons why someone finds themselves in trouble with their lenders. Getting sick, getting hurt or losing your job can all make it hard to pay back money you owe, and that can lead to a low credit score. Often, the reasons we have trouble paying back the money we have borrowed are things we don’t always have control over. This is the best reason to limit the amount of money you have borrowed. If you find yourself owing too much money and something you could not predict happens to stop you from being able to pay it back, it doesn’t just affect your ability to borrow money in the future. It can also affect your ability to get a good job. Your credit score and report may also be used by television, internet and phone companies as well as your local utilities to determine if you qualify for an account with them, if you need to put down a security deposit to connect the service, or if you’re just too much of a risk to do business with the company in question at all.

Having a bad credit score can cause a lot of problems in your life. That’s why you need to make good decisions when choosing what borrowing options are right for you and who to borrow from. You should be educated and understand the different things that can happen that will show up on your credit report. You should understand your own ability to repay the money you have borrowed, and take into account the possibility of future problems.

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Refresh financial offers custom credit building solutions to help you build your credit score FAST.

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