Credit is so much more than just a piece of plastic.
Credit is a financial instrument that proves you can be trusted to borrow money. Credit signals to lenders that you’re responsible and trustworthy. It can be a tool that protects you in times of emergencies and improves your overall financial well-being. Learning about credit and understanding how credit works is an absolute must for all Americans in today’s modern credit-centric society.
What is credit?
Credit is an agreement between a borrower and a lender; money is lent, and there’s a promise to repay that money later. Lenders come from banks, credit unions, credit card issuers, and other financial institutions. Here’s how it works:
Imagine eating at a restaurant and paying for your meal with a credit card. You received food, and the restaurant received money for the meal, but the funds didn’t come from your bank account. Instead, they came from the credit card company whose little plastic card allows you to complete transactions with their money rather than your own.
Credit can also be used to describe someone’s ability to borrow money. You can have “good credit” or “bad credit.” It’s also possible to not have any credit (which we’ll cover later). Conversely, “having credit” can mean you 1.) have money you can immediately access and borrow from or 2.) you have records of previous history where money was borrowed.
If you’re struggling with your credit cards and need help, you can use our Virtual Intelligent Counselor. It’s free, takes only a few minutes, and you can save time before speaking with a counselor.
Is credit bad?
Credit is not inherently a bad thing or something to be afraid of. Credit is a financial tool like a car loan, a mortgage, or even cash. Using it irresponsibly can result in problems, but using it wisely can help you save money and build wealth.
[On-screen text] Are credit cards good or bad?
Gary Herman, President of Consolidated Credit: I happen to love credit cards and not just because I’m in the business of helping people pay off credit cards. There are a lot of very smart ways that people use credit cards – not just for convenience, but also to save money. I would love to see people solve their debt-related and learn really smart ways to use credit cards.
Credit cards often offer multiple points for things like groceries or gas. Some people just use a gas card at the gas station and they save 3-5% on their purchases. Instead of having interest go to the banks, now you’re the one earning a percentage off of every charge.
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Credit has other benefits, too. Strategic credit use can help you:
Make purchases or pay bills if your paycheck arrives after those due dates
Keep cash in your accounts (great for emergencies)
Protect yourself against fraud and theft (since it’s not your “real” money that was used)
Save time and effort – there’s no need to write checks or keep cash on hand, especially for large purchases
Avoiding credit can end up hurting you in the long run. As a country built on credit, not having any can make it extremely difficult to purchase a vehicle, find a place to rent, start a business, or sometimes, even get a job. Money might make the world go round, but credit holds it together and is necessary for all Americans.
Credit cards can be a helpful tool and a vital part of your financial strategy when used correctly. They only cause problems when you don’t have a plan to manage the debt OR use them to cover expenses you can’t afford. Setting some ground rules can help you avoid the financial challenges that credit cards cause.
These resources can help you gain a better understanding of how to use credit and manage credit card debt, so you always maintain control over your finances:
Getting credit is like getting money – acquiring more is easier if you already have it. First, lenders must be convinced that you can repay what you borrow. They’ll examine your income and how much you already owe to others. Even high earners can be denied credit if they have a high debt load.
However, lenders also want to know you’re trustworthy and won’t skip out on the debt. They’re not going to take your word for it. Instead, they will look at your credit report, a comprehensive file with details like…
Every credit card or loan you have held (and every application you’ve ever sent trying to get one)
How often you’ve maxed out your card
Any time you’ve been late or missed a bill payment
This is why it can be tricky to get credit if you don’t already have any – but it’s not impossible. Common ways to build credit include:
Federal student loans: These are obtained by filling out the FAFSA, are based on need, and have no credit score requirements.
Secured credit cards work like standard credit cards, but the borrower must provide cash as collateral to access the credit.
Credit-builder loans: A niche type of loan taken out solely for the purpose of building up a person’s payment history.
Become an authorized credit card user. A primary cardholder can add someone to their credit card account. This person isn’t liable for making payments, but card activity is reported to all users’ credit reports.
These methods can also be used to repair damaged credit, though there are additional actions one would likely take, such as disputing incorrect or harmful credit comments. If you find something unfamiliar in your credit report, you can file a dispute to correct whatever is wrong. This won’t have any impact on credit score.
If you find mistakes or errors in your credit report that you need to dispute, use these free credit repair instructions to repair your credit so you can maximi…
A credit report is a statement that contains all past and present credit activity. Banks, credit card companies, landlords, and even the courts provide this information to credit bureaus, which compile it. The main credit bureaus are Equifax, Experian, and TransUnion.
Using data from a credit report, each credit bureau calculates on a scale of 300-850, and that number becomes a person’s credit score. Credit scores can heavily influence interest rates and borrowing terms.
Not all credit bureaus have all the same information, as some lenders only report to some bureaus and not others. It’s also fairly common for bureaus to make mistakes – about one in five credit reports have mistakes. To check for errors, a person can receive a free copy of their credit report from each credit bureau once every 12 months from AnnualCreditReport.com.
Types of credit
There are three common types of credit: revolving, installment, and open credit.
A revolving line of credit means there’s a maximum amount you can borrow (known as a credit limit), and you can repeatedly borrow up to it as long as your account is open. For example, say you have a credit limit of $10,000. If you spent $2,000 on the card, you’d still have $8,000 available to borrow. Once you repay that $2,000, you’ll have the full $10,000 available again.
Revolving credit is the type you’re most likely familiar with since it’s the most commonly used form of credit – you guessed it, credit cards. Another type of revolving credit is a HELOC (home equity line of credit), which works like a credit card, but the amount you can borrow is based on the value of your home.
Next is installment credit, a fixed borrowed amount typically dispersed in a lump sum and repaid in the same amount each month (known as installments). Types of installment credit include loans such as student loans, auto loans, mortgage loans, home equity loans etc. Installment credit is different from revolving credit in that paying down the balance does not increase the amount that can be borrowed, and repayment is broken up into amounts that are the same every month.
Finally, there is open credit. Sometimes mixed up with revolving credit, open credit is unique in that there is usually no set limit on how much can be borrowed, but the entire balance must be paid once it becomes due. The most common type of open credit is charge cards. They appear and function identically to credit cards, but charge cards usually don’t have preset credit limits, and users aren’t able to carry a balance. They are also a lot less commonly used than credit cards.
Credit can also be further broken down by how the credit limit is derived. There’s secured credit, which refers to any type of credit that’s backed by collateral – a financial asset like a piece of property, a vehicle, or even cash counts. The amount of credit given is usually directly correlated to the value of this collateral and should you default, that asset would be taken as payment. Credit issued without collateral is known as unsecured credit. Lenders determine lending limits based on things like your credit score, credit history, and income.
Basic credit terms and definitions
APR (annual percentage rate): The privilege of borrowing money comes at a cost, usually a percentage of the total amount borrowed. Often used interchangeably with the term ‘interest rate’ or ‘interest’, this number represents how much the balance would increase over a year if a balance were held. For example, a carried balance with a 22% APR would increase by approximately 22% over a year.
Balance: The total amount owed on a line of credit, does not necessarily reflect what is expected in an upcoming monthly payment.
Billing cycle/billing period/statement period: The number of days between credit card statements; typically 30 days.
Closing date: This marks the end of the current billing cycle. Purchases made before the closing date will be included in the upcoming monthly statement (i.e., the bill); those made after the closing date will be included in the following month’s statement.
Credit card statement: A summary document given at the end of a billing cycle that details all cardholder information, including transactions, total balance, interest, and other charges.
Credit limit: The maximum amount of money that can be borrowed by the account holder.
Minimum payment: The lowest amount you can pay while remaining in good standing with a lender.
Statement balance: The amount of money owed in the upcoming payment. It can differ from the total balance, depending on whether purchases were made before or after the closing date.
Term: The length of time available to repay a loan does not apply to credit cards. Often listed in years or the number of payments.
Transactions: Purchases made using a credit or charge card.
How does credit card debt work?
Credit cards are the biggest source of consumer debt, second only to mortgages, and they are the type of debt most likely to get borrowers into trouble.
The world of credit doesn’t have to be so confusing. Here’s a simple 60-second explanation of how credit card debt works.
Credit card debt is revolving. This means the more debt you put in by making charges, the higher your bills are coming out the other side. So, the amount you owe each month changes based on how much you charge.
Each payment you make is split into two parts: Paying off interest added and paying off actual debt. If you only make the minimum payments required, the bulk of each payment made goes to interest. As a result, it takes a long time to pay off your debt and credit card purchases can end up costing double or triple the purchase price with interest added. Plus, if you rely too much on credit, your payments can get so big that you don’t have enough money to cover all the expenses in your budget.
If you want to be financially successful, you have to keep credit card debt minimized. We can help. Call Consolidated Credit today for a free debt analysis with a certified credit counselor.
Carrying a balance
The No. 1 mistake people make with credit cards is carrying a balance. Carrying a balance means paying interest. Those interest fees are tacked onto the original balance, creating a new higher balance that means even higher interest charges the following month, so on and so forth. If you’re only making minimum payments, most of your money goes towards interest payments rather than the principal balance, making it nearly impossible to get out of credit card debt.
Another common cause of credit card debt is not understanding credit card fees. Like any other business, credit card companies need to make money, and one way they do this is through a variety of fees. Late fees are common, but you should also watch out for high annual fees, balance transfer fees, and more.
By extension, another big problem with plastic is high annual percentage rates (APR). Credit cards have a much higher APR than other types of credit, like mortgages or auto loans. Average interest rates are upwards of 20% (mortgage rates, by comparison, average around 6-7%), making credit card debt the most expensive kind to have. If making minimum credit card payments, nearly two-thirds of every payment gets eaten up by interest charges.
This table shows you the total interest charges you can expect to pay on a $5,000 credit card balance if you make minimum payments.
The final piece of good credit management is understanding how your rights as a consumer are protected under federal law. Key consumer protection rights help prevent predatory lending and other unfair lending practices, collector harassment, and credit abuse. Knowing what these laws say can help ensure that every creditor, collector, or financial professional you work with is doing what they should be doing to help you.
