What is credit and how does it work? We often forget the very basics behind credit as we go about our lives buying things (often on credit) and making payments on the monthly bills. Of course most recently the housing fallout and matters of subprime loans have only made the waters muddier but at least opened up the conversation around credit and how it really works.

At its most basic, credit is when Person A makes a purchase (usually of a large sum) with money that has been given to them by Person B (usually an institution) with the understanding that Person A will repay Person B over a specified period of time. For the privilege of doing this, Person A pays Person B a premium usually in the form of a percentage of interest of the total amount borrowed.

It sounds so easy to understand, yet in many cases the underlying terms of the borrowing agreement get so complex that people don't even know what they are really signing on for (either that or they choose to feign ignorance and ignore the facts).

Whenever you need to borrow money, a lender looks at your credit report. At How Stuff Works, they have a nice article on "Understanding Credit Reports" but essentially:

A credit report is an accumulation of information about how you pay your bills and repay loans, how much credit you have available, what your monthly debts are, and other types of information that can help a potential lender decide whether you are a good credit risk or a bad credit risk.

Every time you apply for a credit card or other type of loan, the lender will pull your credit report and review it to determine your risk profile. If your risk profile is not good, you will pay more in interest for the money that you borrow (or get denied a loan altogether). So it pays to have a positive profile. The quickest way for a lender (and you) to assess your credit worthiness is by looking at your credit score. In "How Credit Scores Work" it states:

A credit score is a number that is calculated based on your credit history to give lenders a simpler "lend/don't lend" answer for people who are applying for credit or loans. This number helps the lender identify the level of risk they may be taking if they lend to someone. While the same end result can come through reviewing the actual credit report (which lenders usually do), the credit score is quicker and less subjective.

The most commonly used score is the FICO score. It ranges between 300 and 850 and the higher your score the better off you are.

Types of Credit

There are essentially two main types of credit: installment loans and revolving debt.

Installment loans involve a fixed amount of money borrowed for a fixed amount of time with fixed term payments. (Notice the emphasis on fixed?) Examples of installment loans include home mortgages and car loans. Even if you have a variable interest rate on the loan (as some home mortgages do) you still have a fixed amount that you borrowed up front and a fixed period of time over which to make the payments.

Revolving debt is a line of credit extended to you which you can choose to use or not use. Examples of this include credit cards and home equity lines of credit. You are approved for a credit line (say $20,000) and you can use as little or as much of that as you like at any given time. Your available credit at any given point in time is your credit line plus any finance charges less any current balance due. In this example if you had a credit line of $20,000, finances charges due of $50 and you had a balance of $5000, you'd have an available line of $14,950. You get assessed a fee based on your average balance using an interest rate that varies over time based on the current lending rates, your credit score, and your repayment habits.

Credit can be a great way to navigate big purchases and manage cash flow as long as you remember that money is not free. There is a cost associated with borrowing money and the more debt you have, the lower your net worth is. So you must evaluate the use of credit based on your current financial situation and goals.

Paula Gregorowicz, owner of The Paula G. Company, works with women who are ready to create their lives and businesses the way the want rather than how they were told they "should". She is the author of the 12 part eCourse "How to Be Comfortable in Your Own Skin" which you can download for free at her blog http://www.coaching4lesbians.com.

To get the latest word on personal finances from an LGBT perspective and Paula's practical coach approach to the topic check out Queercents http://www.queercents.com.

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