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What is credit?
Credit is issued to people who want to obtain something now, but who can’t or don’t want to necessarily pay for it now, based on that person’s ability to pay for it later. Credit can be used to purchase new property or to take out a loan, and a person’s creditworthiness is represented in different ways, including as a dollar amount called a line of credit or as a three-digit credit score.
Credit is the measure of trust one party has in another party’s ability to receive some kind of resource now and pay for it at a designated point in the future. In most cases, that means a person in relation to her bank. Banks issue the vast majority of credit, acting as a third party when the person uses the credit as money to make a transaction. Credit spent in this way incurs a debt, which must be paid off within a designated time or it will accrue interest and other penalty fees.
Banks issue two kinds of credit: secured credit, which is backed up by collateral or a lien, and unsecured credit, which isn’t. A mortgage is a kind of secured credit, with the homeowner’s property put up as collateral; a credit card is a kind of unsecured credit, with the customer’s ability to pay the only thing protecting the bank.
Creditworthiness is measured by a credit bureau, which generates a credit history based on a person’s income or ability to make payments on time, and which is expressed numerically by a credit score that ranges from 300 to 900. With a high credit score, she will most likely receive a larger line of credit when she applies for one. Accordingly, a person with no documented credit history or negative marks on their credit history is usually only eligible for a small amount of credit. Credit also plays in a role in how much a bank is willing to loan customers and what sort of terms borrowers must adhere to.
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Clara opens her first credit card at 19 because she doesn’t have a credit history and would like to start building one. Because she’s in school and has little income, she’s offered a credit card with a $500 credit limit, which is typical for people in her situation. The credit line goes into effect immediately, and she’s able to start making purchases on with the card.
At the end of her monthly billing cycle, she’s made $246 in charges on the card, so she has to pay the $246 back to the issuing bank. She could choose not to pay it, or pay only a small amount, in which case her credit score will take a major hit and she will incur interest on the balance that would make it even more difficult for her to pay it off on the next billing cycle.