Many of us use credit to buy all types of goods and services, including food, clothing, housing, transportation, etc. Although it is so widely used, there is often confusion about the basics of how it works. Today, we will set the foundation of what credit is and why it is so important. We will continue for a series of articles focused on credit that will feature tricks and tips on how to best utilize credit, how to improve your credit score, your credit history, and more.
Let's begin with the basics...
What is Credit?
According to Experian, "Credit is the ability to borrow money or access to goods or services with the understanding that you’ll pay later."
There are 3 types of credit:
1. Revolving Credit
Revolving credit is what is most commonly known as "credit cards". With this type of credit, you have a limit to how much you can borrow from a financial institution (like a bank or credit card company) and you must make a minimum payment each month. The amount that you do not end up paying is charged "interest" (the fee you pay the financial institution for letting you borrow the money in the first place, aka how the banks make a lot of their money).
2. Open Credit
Open credit is a type of credit that isn’t used as much as credit cards, but is still used in the form of "charge cards". Today, American Express is a primary issuer of charge cards in the electronic payment industry. They are similar to credit cards; however, there are no limits to how much the financial institution is lending you. But when it’s time to pay the bill, you must pay the full amount. If you are not able to, the company will shut the accounvt down until the balance is paid.
So...what exactly are the benefits of using a charge card? Charge cards provide all the benefits of a credit card – convenience, rewards, fraud and purchase protection, etc. – without the opportunity to overspend and go into debt for long periods of time.
3. Installment Credit
These are loans for a specific amount of money that you agree to pay back, with interest and fees, in a series of monthly payments (installments) over a set period of time, usually years. Student loans, auto loans, and mortgages are examples of installment credit. This type of credit allows you to obtain pretty expensive things like a car or a home, even if you can't afford to pay in full. Keep in mind, you will be paying more in the long term since you are paying interest. In addition, you will need to make sure that you can afford to pay these installments for the time period you agree to pay it.
Why is Credit Important?
Credit is important because it defines, in a big way, your financial buying power. Having good credit allows you to purchase the things you need today, and allows you to qualify for other things you need good credit for (such as home, auto, business loans) when you need them later. Your credit score is a number between 300 and 850. A high credit score demonstrates to other financial instituations that you are a trustworthy borrower.
In our next blog post about credit, we will discuss best practices to build your credit and improve your credit history.
If you have more specific questions, visit our "Schedule A Meeting" Page to schedule a 15 minute meeting with one of us. We'd be happy to help!
In good financial health,
Tori