Chapter 1: What is Credit?

In the broadest sense, credit means having the use of something before you pay for it. It adds flexibility to planning and makes it possible to pay for expensive items over a period of time. Credit comes in many different forms, and it is important to understand how each works so you can obtain the right type for your needs.

Secured Credit
This is commonly used to purchase a large item, such as a home, car, or appliance. An asset (most often the item purchased) called collateral secures the loan. If you do not keep the monthly payment arrangement, the creditor has the right to reclaim the collateral. There are two types of secured credit:

  • Secured/closed-end – With a secured/closed-end credit instrument, a set amount is borrowed up front, and you cannot borrow more from it later. The balance is usually repaid in equal installments over a specific period of time. Mortgages and car loans are an example of this type of credit.
  • Secured/open-end – With a secured/open-end credit instrument, you are given a credit limit, and you can repeatedly borrow up to that amount. With a secured credit card, you can usually borrow as long as the account is open. With a home equity line of credit, you can only borrow for a fixed period of time (called the draw period). The minimum required payment is typically based on the current balance (amount owed), so it can vary from month to month.

Unsecured Credit
This is credit extended without collateral (security). Because of the higher risk to lenders, unsecured credit generally carries a higher interest rate than secured credit. It can be:

  • Unsecured/closed-end – Like with its secured counterpart, a set amount is borrowed up front, and the repayment is typically made in equal, monthly installments. An example is a debt consolidation loan.
  • Unsecured/open-end – You are given a revolving line of credit that you can continue to borrow from as long as your account is in good standing. The minimum monthly payment is based on the current balance. Credit cards are the most common form.

Credit Cards
There are several types of credit cards on the market:

  • General-purpose credit cards can be used virtually anywhere. If you have both an excellent credit history and a high income, you may be offered a “premium” card (sometimes called Gold or Platinum), which comes with a high credit limit and enhanced customer service. Some credit cards offer points, rebates, or cash-back rewards where the more you use them, the more benefits you receive.
  • Retail cards may only be used at a particular retail establishment, such as a department store or gas station.
  • Small business cards offer special perks to business owners and their employees.
  • Student cards generally offer lower credit limits and special benefits for students.
  • Secured credit cards require you to put down a deposit as collateral and are typically used by people who are trying to establish or reestablish good credit.

Charge Cards
A charge card is similar to a credit card, but you have to pay the entire balance in full each month (although some card issuers may allow you to pay for specific purchases over time). The credit limit is often very high or even unlimited. If you cannot make a full payment, a high interest rate and late fee may be assessed. Collection action can
be swift and severe.

Debit Cards
It is important to not confuse debit cards and credit cards. Because the money is deducted from your checking account right away when you use a debit card, it is not a type of credit.