Credit: What It Is and How It Works

Credit is the arrangement that lets a borrower receive money, goods, or services now and repay the lender later—usually with interest. The term also describes an individual’s or company’s creditworthiness and has a specific meaning in accounting as a bookkeeping entry.

Key takeaways

• Credit can mean a lending agreement, a measure of creditworthiness, or an accounting entry.
• Common credit forms include loans, credit cards, lines of credit, and trade credit.
• Credit scores and credit ratings summarize borrower risk for lenders and investors.

Credit in lending and borrowing

Credit is an agreement between a creditor (lender) and a debtor (borrower). Typical forms:
* Consumer loans: mortgages, auto loans, personal loans.
Credit cards: a revolving line of credit where the issuer pays merchants and the cardholder repays the issuer.
Lines of credit: funds available to draw as needed (e.g., HELOC).
* Trade credit: a seller allows a buyer to pay later for goods or services.

If the borrower fails to repay, consequences can include higher interest rates, damaged credit, collection actions, or legal penalties.

Creditworthiness and ratings

Creditworthiness is an assessment of how likely a borrower is to repay debts. For individuals, credit scores (e.g., FICO) summarize this risk; for companies and governments, credit rating agencies (Moody’s, S&P) assign letter-grade ratings that affect borrowing costs.

Typical FICO score categories (300–850):
* 800–850: Exceptional
740–799: Very good
670–739: Good
580–669: Fair
300–579: Poor

You can review your credit reports for free annually from the three major U.S. bureaus at annualcreditreport.com.

Credit in accounting

In double-entry bookkeeping, a credit entry typically:
* Increases liabilities or equity, or
* Decreases assets.
A debit does the opposite. Example: buying inventory on credit increases Inventory (debit) and increases Accounts Payable (credit).

How credit scores are calculated

Credit scores weigh multiple factors; common categories include:
* Payment history (most important)
Credit utilization (amount owed vs. available credit)
Length of credit history
Credit mix (types of accounts)
Recent credit inquiries and new accounts

Improving a score can take months to years depending on the issue.

Common credit terms (FAQs)

• Letter of credit: A bank guarantee used in trade that assures a seller will be paid by a certain date; the bank pays if the buyer does not.
• Credit limit: The maximum a lender will allow a borrower to owe on an account (credit card, line of credit).
• Line of credit: A flexible loan amount borrowers can draw from as needed (repaid and redrawn while the line is open).
• Revolving credit: Credit without a fixed term (e.g., credit cards). Closed-end credit (mortgages, car loans) has a fixed repayment schedule and end date.

How to improve your credit

• Pay all bills on time—consistent on-time payments build history.
• Lower credit utilization—aim to use a small percentage of available credit (commonly recommended under 30%).
• Avoid opening unnecessary new accounts and limit hard inquiries.
• Keep older accounts open to preserve average account age.
• Diversify credit responsibly (installment and revolving accounts).
• Review credit reports for errors and dispute inaccuracies.

Bottom line

Credit enables purchases and business activity today with repayment later. Understanding the types of credit, how creditworthiness is measured, and practical steps to maintain or improve credit helps you access better borrowing terms and lowers long-term costs.