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What is Credit? Understanding How Credit Works

Updated on January 3, 2011
Credit is money or property given in exchange for promise of payment.
Credit is money or property given in exchange for promise of payment.

It may seem elementary to ask the question, “What is credit?” Most people think of it in terms of their credit score, which is something entirely different.

How Credit Works

Credit is a consideration such as a car, a home or money given to an individual or organization in exchange for promise of payment. When you take out a loan or pay for something with a Visa card, you are using credit. The loan amount you qualify for is based largely on your financial history.

You have credit you have used and that which is available to you for use in the future. You will see an example of this on your credit card statement. The balance is what you have used, or the money you owe the creditor. Your available credit is how much more money the company is willing to extend to you in exchange for your payments.

When you use your credit to buy something, the creditor or lender pays for that product and recoups their money from you. With a mortgage, the lender pays for your home. The house is yours to live in, but the lender holds a lien on your home until you pay off the mortgage. Your monthly payments reduce the amount you owe the lender. The difference between what you owe and what the property is worth is your equity, or your interest in the property.

A mortgage is a secured debt. The house is the consideration you receive in exchange for payments. If you do not make your scheduled payments, the lender can foreclose on the property and repossess the home. You lose not only your home, but the equity you have gained in it as well.

With a home equity line of credit, a lender agrees to advance a certain amount of money to you in exchange for the interest you own in your home. The HELOC allows you to access that money as you need it. As with a bank card, you will have credit you have used and that which is available to you.

Once you understand what credit is, it is much easier to understand how credit scores are determined and why a good score is so valuable.

References:

Chase.com

LexingtonLaw.com

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