Credit, at its most basic level, is trust in the form of money.
This is a deal where the lender gives you the money or the products or the services, and trusts you that you will give them back the money with some extra charge known as interest in return. Each time you use your credit card, borrow money for college education, and buy a house through mortgage, you have used credit.
How Credit Actually Function
Credit is basically a function of how two people interact, namely, the lender and the borrower.
- The Principal: This is the initial amount of money borrowed.
- The Interest: This is the rate charged on borrowing the money, expressed in percentages of the principal.
- The Term: This is the predetermined period within which you need to pay off your debt, either after 30 days in the case of a credit card or 30 years in the case of a mortgage.
Using credit sensibly and making your payments on time makes you a low risk to the lender. If otherwise, you are considered a high-risk customer.
Four Main Kinds of Credit
All credit is not alike. There are four basic kinds of credit you will experience in real life:
- Revolving Credit: You are allowed a certain amount of credit that can be borrowed again and again as long as you keep up your payments. Examples would include credit cards and personal lines of credit.
- Installment Credit: This credit includes borrowing a single sum of money and repaying it through predictable monthly installments. Examples would include mortgages, auto loans, and student loans.
- Open Credit: These kinds of accounts involve paying the total cost of something at the end of each month without any remaining balance, like utility bills or some charge cards.
- Service Credit: This includes agreements made with your service providers, such as your cell phone carrier, Internet provider, or even the gym.
Why Your Credit Is Important
Credit is much more important in today's economy than simply acting as a financial cushion.
Your financial reputation is your credit score; the three-digit number that represents how good your credit is. A great credit score will afford you the opportunity to earn low interest rates, save money by avoiding lifetime interest payments, no apartment security deposits, and even an advantage in the job market when credit is essential to your job.
Using credit correctly allows one to gain the benefit of the leverage, the rewards, and the protection offered by consumer credit. Abusing the system through debt caused by compound interest is sure to land you in a financial cage of your own making. The first step to financial freedom is recognizing that credit is financial leverage and not "free money."
