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.
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.
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.
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.