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Credit is a contractual agreement in which a borrower receives something of value immediately and agrees to pay for it later, usually with interest.
What Is Credit?
Credit is a contractual agreement involving borrowing, then repaying with interest. A borrower receives a sum of money or something else of value and commits to repayment to the lender later, typically with interest.
In addition to that lending scenario, credit serves as an indicator of creditworthiness, or the credit history of an individual or a company. It’s important to maintain good credit (a history of reliably repaying what you owe on loans) to get approved for loans like mortgages and get the best interest rates on them.
In accounting, credit refers to a specific type of bookkeeping entry.
Credit scores serve a critical role in assessing borrower risk. A bad (low) credit score can take months or years to improve and can keep you from getting the most competitive loan rates.
Key Takeaways
- Credit is an agreement where a borrower receives something of value now and agrees to repay it later, usually with interest.
- Good credit history can help secure loans and favorable interest rates.
- In accounting, a credit is a bookkeeping entry that decreases assets or increases liabilities, opposite to a debit.
- Credit scores classify individuals by risk and range from 300 to 850, with higher scores indicating better creditworthiness.
- Credit can be revolving, like with credit cards, allowing ongoing borrowing up to a limit while being replenished as repayments are made.
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Sydney Saporito / Investopedia
Understanding Credit: Lending and Borrowing Dynamics
Credit is an agreement between a creditor (lender) and a borrower (debtor). The debtor promises to repay the lender, often with interest, or risk financial or legal penalties.
There are many different forms of credit. Common examples include car loans, mortgages, personal loans, and lines of credit. Essentially, when the bank or other financial institution makes a loan, it “credits” money to the borrower, who must pay it back at a future date.
Credit cards let you buy almost anything on credit. The bank pays the seller in full and extends credit to the buyer, who then repays over time with interest.
Similarly, if buyers receive products or services from a seller who doesn’t require payment until later, that is a form of credit. When a restaurant gets produce from a wholesaler who bills them a month later, it’s a form of credit.
Broader Interpretations of Credit
Credit is also used as shorthand to describe the financial soundness of businesses or individuals. People with good credit are seen as less risky to lenders than those with poor credit.
Important
Credit scores are one way that individuals are classified in terms of risk, not only by prospective lenders but also by insurance companies and, in some cases, landlords and employers. For example, the commonly used FICO score ranges from 300 to 850. Anyone with a score of 800 or higher is considered to have exceptional credit, 740 to 799 represents very good credit, 670 to 739 is good credit, 580 to 669 is fair, and 579 or less is poor.1
Credit rating agencies like Moody’s and S&P give companies letter-grade scores based on financial strength. Bond investors watch these scores closely, as they affect the interest rates companies must offer to borrow. Similarly, government securities are graded based on whether the issuing government or government agency is considered to have solid credit. U.S. Treasuries, for example, are backed by the “full faith and credit of the United States.”
In accounting, “credit” has a specialized meaning. It refers to a bookkeeping entry that records a decrease in assets or an increase in liabilities (as opposed to a debit, which does the opposite). For example, suppose that a retailer buys merchandise on credit. After the purchase, the company’s inventory account increases by the amount of the purchase (via a debit), adding an asset to the company’s balance sheet. However, its accounts payable field also increases by the amount of the purchase (via a credit), adding a liability.
How Is Your Credit Score Determined?
Lenders use your credit score, a number from 300 to 800, to see if you’re a reliable borrower.
Five factors determine your credit score: payment history, credit usage, credit history length, credit mix, and recent credit applications.
If you have a high credit score, you may be considered to have good credit. If you have a low credit score, you can take steps to improve it. In many cases, it can take months or years to improve your score so that you can get the most competitive rates on loans.
You can check your credit report for free once a year from Equifax, Experian, and TransUnion at www.annualcreditreport.com.
What Is a Letter of Credit?
Often used in international trade, a letter of credit is a letter from a bank guaranteeing that a seller will receive the full amount that it is due from a buyer by a certain agreed-upon date. If the buyer fails to do so, the bank is on the hook for the money.
What Is a Credit Limit?
A credit limit represents the maximum amount of credit that a lender (such as a credit card company) will extend (such as to a credit card holder). Once the borrower reaches the limit, they are unable to make further purchases until they repay some portion of their balance. The term is also used in connection with lines of credit and buy now, pay later loans.
What Is a Line of Credit?
A line of credit refers to a loan from a bank or other financial institution that makes a certain amount of credit available to the borrower for them to draw on as needed, rather than taking all at once. One type is the home equity line of credit (HELOC), which allows owners to borrow against the value of their home for renovations or other purposes.
What Is Revolving Credit?
Revolving credit involves a loan with no fixed end date—a credit card account being a good example. As long as the account is in good standing, the borrower can continue to borrow against it, up to whatever credit limit has been established. As the borrower makes payments toward the balance, the account is replenished. These kinds of loans are often referred to open-end credit. Mortgages and car loans, by contrast, are considered closed-end credit because they come to an end on a certain date.
How Can You Improve Your Credit?
You can improve your credit by reducing your debt utilization ratio, which is the amount of debt you are using compared to your available credit line. You can also ensure you make all your payments on time and avoid opening new credit.
The Bottom Line
Credit is both a contractual agreement for borrowing and a measure of creditworthiness. It has implications in lending and borrowing scenarios, such as personal loans and mortgages.
Maintaining a good credit history secures you favorable interest rates, and earning a high credit score heightens your financial profile not only with lenders but also with employers, insurance companies, and landlords.
Credit is also a bookkeeping entry in accounting, balancing assets and liabilities.
There are different types of credit, including revolving credit (which allows the borrower to repeatedly borrow up to a certain limit) and lines of credit (which allow users to access funds up to a set limit and repay as needed).
Credit reports should be checked regularly not only to ensure accuracy, but also as a strategy for improving credit scores over time.
Credit serves a critical role in making commerce run smoothly. Understanding its various forms can empower individuals to make informed financial decisions.
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