Categories: Financial Planning, General Tips
The concept of credit is a critical one for everyone and the earlier you understand how credit works and affects your entire life, the better off you’ll be in navigating your financial future.
What is Credit?
Simply put, credit is the ability to borrow money for things you want or need now with the promise that you’ll pay it back later. Using credit — whether it be via a credit card or through loans like mortgages — typically comes with a price. For the privilege of borrowing money to use now, you’ll have to pay back the amount borrowed (the principal) plus a bit more. This additional amount is called interest, and it’s calculated as a percentage of the principal. How much interest you pay depends on many factors, the two most critical usually being income and credit score.
What is Debt?
Debt is the amount of money you owe to any lenders from whom you’ve borrowed. For example, if you’ve taken out a car loan of $10,000 to be paid in monthly installments for 36 months at 4% interest, you have $10,628.63 of debt to that lender. Beware: missing a payment is likely to add to your debt and can affect your credit score. (See “How Credit Affects You” below.)
Different Types of Credit
There are three main types of credit. Understanding each will help you evaluate your financial needs throughout your life.
- Revolving Credit
Revolving credit gives you a maximum amount you can borrow. You can pay off your debt in total each month, or little each month such as by paying the minimum payment the lender specifies. Keep in mind that by not paying in full every month, you’ll be charged interest on what you still owe, which will add to the total debt. Personal lines of credit and credit cards are examples of revolving credit. - Installment Credit
Installment credit has fixed payments, typically made monthly. Again, if you don’t pay the monthly amount specified, you’ll be charged interest on what you owe and may also incur additional fees. Car loans are an example of installment credit. - Open Credit
Open credit is a bit more nuanced because it requires a lump payment. Old fashioned store charge cards worked this way, but another good example is a utility or cell phone bill. You’re being allowed to use a service up front (i.e., electricity) for the promise to pay it back at the end of the month.
How Credit Affects You
You’ve no doubt heard about credit scores, either from your parents or ads on TV. A credit score is a number between 300-850 that tells a lender how creditworthy you may be. That is, how likely you are to fulfill your loan obligation without making late payments or defaulting (not being able to pay it back). Your credit score is based on many factors from your credit history, and it can change over time depending on how much you borrow, how responsibly you pay it back, and a number of other elements such as the length of your credit history.
Your credit score is part of your entire life, so starting to take care of it early in your financial life can have an impact on future credit needs. Paying your bills on time, only taking out credit that you need, and keeping your debt in check are three of the best ways to manage your credit score.
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