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The Definition of Credit and Why You Need It

8 min read
Last Updated: April 10, 2025
Getting a credit card

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Key Takeaways

  1. Credit is a system that allows you to borrow money to make purchases on the condition that you pay it back.

  2. Lenders determine whether to give you credit based on your credit score and the information in your credit report.

  3. You can take steps to improve your credit with responsible credit habits, like paying your bills on-time and keeping your credit usage low.

When you open a credit card account or take out a personal loan, you use credit. With credit, you can borrow money from a lender for purchases on the condition that you’ll pay back the money later, sometimes with interest. Credit is one way that you can increase your spending power beyond the cash you have on hand or in the bank. Understanding how credit works and why it matters can make it easier to build a positive credit history.

Credit definition

Credit is an important tool in one’s financial toolbox. But it’s important to understand exactly what credit means so you can use it responsibly.

“Credit” is an agreement or system that allows one party to receive something valuable now, including access to funds, and provide payment later. When people say “credit,” they typically mean loans and credit cards or lines of credit from a financial institution.

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Why is good credit important?

A high credit score may show lenders that you practice good financial habits, like paying your bills on time and keeping your credit utilization low. A low or poor credit score may signal more credit risk, because it points to a high credit utilization ratio or history of missed payments.

Ultimately, multiple factors—including your credit score and income—may determine whether lenders approve you for various credit products. Each lender has unique processes and priorities. But, generally, a higher credit score makes it easier to qualify for the best credit cards and loans possible.

How do you use credit?

While specific processes vary depending on the lender and financial product, credit basically works like this:

  1. You apply for a loan, credit card, or line of credit. Typically, you can do this in person at a bank, credit union, or credit card company, over the phone, or online with a digital banking tool.
  2. If the lender determines that you’re creditworthy, you receive a credit offer with specific terms, like the repayment period, credit limit, and interest rate.
  3. You use the credit to make purchases. Depending on the type of credit, you might use it as needed or for a specific expense.
  4. You repay the credit according to the terms you agreed to, often with interest.
  5. Over time, you may build good credit history.

Types of credit

A lender like a bank, credit card company, or credit union, may offer a wide range of different credit products designed to address different goals and situations. But the majority of credit products fall into one of two categories: revolving credit and installment credit.

Revolving credit: When you open a revolving credit account, the lender allows you to borrow continuously up to a set amount of money, your credit limit. If you reach that limit, you have to repay a portion of your balance to restore your available credit before you can borrow from the credit line again. In other words, a revolving credit account is a line of credit that you can borrow against as often as you’d like if you pay at least the minimum amount due on your bill and remain within your credit limit. Credit cards are a common form of revolving credit.

Installment credit: Installment credit accounts (or installment loans), on the other hand, allow you to borrow a fixed sum of money all at once from a lender. You normally repay the loan through a series of installments over a set repayment period. Installment loans can include a personal loan, student loan, or car loan, for example.

How does credit work?

Your ability to manage different forms of credit responsibly may impact your creditworthiness. Your credit card and loan activity usually appear on your credit report. Lenders often use both your credit score and credit report to decide whether they should approve your credit application and determine your terms.

Credit report

A credit report is a record of your borrowing history. Your report contains information about how you manage your past and present credit accounts, like your payment history, the age and status of loan and credit card accounts, and your current outstanding balances. According to the Federal Trade Commission, you can check your credit report from each credit bureau for free every week at annualcreditreport.com.

As you use your card and other forms of credit, lenders report your activity to credit bureaus (also known as “credit reporting agencies”). The three major credit bureaus are Equifax®, Experian®, and TransUnion®. Each bureau organizes that information into a credit report. You may have multiple credit reports because the credit reporting agencies may receive slightly different information or process information differently.

Credit score

According to the Consumer Financial Protection Bureau, your credit score is a three-digit number based on information in your credit report. Your credit score uses your past activity and habits as a borrower to determine your credit risk, or how likely you are to pay your debt on time. Credit scoring agencies may focus on different aspects of your credit report, so you typically have several different credit scores.

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Why do you need credit?

Your credit history plays a key role in your overall financial well-being. A good credit history shows lenders and others that you’re responsible and trustworthy, making it easier to open a new credit account. Keep in mind that different credit products may require different credit scores. You might need credit in order to access the following:

Credit cards

When you apply for a new credit card, the credit card company typically performs a hard credit check, which means they view your credit file. Good credit may give you more card options with better terms, like a higher credit limit and a lower annual percentage rate (APR). If your credit score isn’t as high as you’d like it to be, or you haven’t yet started building credit history, don’t panic. Some credit cards don’t always require a credit score.

Did you know?

You can build your credit with responsible use1 of the Discover it® Secured Credit Card. There’s no credit score required to apply.2 Instead, you provide a refundable security deposit, which will equal your credit line, of at least $200.3

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Mortgages and auto loans

You may also need credit when you try to buy a home or car. Unless you can make the total purchase upfront with cash, you typically finance a home loan with a mortgage and a car with an auto loan. Having good credit may help you qualify for a home or car loan with a lower interest rate and favorable repayment terms. Interest rates are important, because the higher your rate, the more you may end up paying over the life of the loan.

Rental housing

When you apply to rent an apartment or house, the landlord may check your credit history. If you have a good credit score, the landlord may feel more confident that you’ll be able to make your monthly rent payments and approve your application. A poor credit score doesn’t necessarily mean you won’t be able to rent, though it may limit your options.

Utilities and cell phone contracts

Your credit may also be a factor when you set up utilities or get a new cell phone contract. The FTC explains that you may have a harder time accessing utilities if you have a lower credit score. You can check local or state laws to see if there are rules that utility or cell phone companies must follow if they want to review your credit score. You may be required to put down a security deposit if you do not meet the provider’s credit requirements.

How can I improve my credit?

If bad credit habits or challenging circumstances have left you with a lower credit score than you’d like, you may build positive credit history with the following responsible habits.

Your payment history is an important part of your credit score. You should aim to pay your credit bills on time, every time. A single missed payment can damage your credit score. A history of late payments may make financial institutions believe you have trouble repaying your debts, making them less likely to extend you credit.

The amount of credit that you’re using compared to your overall available credit is called your credit utilization ratio. High credit utilization hurts your credit score. Your credit utilization typically makes up 30% of your credit score, so it’s important to pay down your balances as much as possible. High credit utilization may make it seem like you can’t manage additional credit.

It’s important to regularly check your credit report for any errors or activity you don’t recognize because these may be a sign of identity theft. If you see an error on your credit report, you can dispute it with the credit bureaus or the creditor directly. If the credit reporting agency or the creditor confirms that an error happened, they should take steps to remove the error from your credit report. Some credit card issuers and other services offer credit monitoring tools that automatically flag suspicious activity.

The bottom line

Credit can help you get the funds you need to invest in your future, whether it’s purchasing a new home, buying a new car, or starting a new business. It’s essential to understand the importance of maintaining good credit and managing debts responsibly.

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