What is Credit?
Credit is a measure of how trustworthy you are with your money. It shows a record over time of how well you meet your financial obligations. This is reflected in a credit score. The better your credit score, the more likely a company will see you as an acceptable risk to take, and will lend you money. A company, say a loan company or a credit card company, extends you the privilege of using money you do not have. In exchange, they charge you extra each month in the form of interest. Then, you make payments that are designed to pay off the interest, then the original loan amount, over a set period of time.
Interest and the 0% Interest Trap
Credit isn’t free, unless there is a 0% interest rate. In fact, any time you use credit with interest above 0%, you will ultimately pay much more for whatever it is that you are buying. Even if the interest rate is 0%, beware of fine print. Often these are introductory offers that come with stipulations. Many times, the stipulations include having to pay in a specific amount of time, and if that doesn’t happen, then a lump interest sum is added to the amount you owe from that point on. So, say you had a 0% interest loan on a $1,000 mattress. The fine print shows that you have 6 months to pay for that 0% interest, but if your payments extend longer, the rate reverts to 22%. They would add $220 to your balance at 6 months, and from then on, whatever your balance was at the end of the month would also have 22% added to it. It would be extremely easy to get behind if you could not afford to pay the extra each month, or were unable to pay in the allotted 6 month initial period.
Credit cards work similarly, and are an easy way to get yourself in over your head. Many come with the introductory low interest rate. Wracking up a huge balance for that rate, though, is a dangerous game. You will have to pay it off in the specified period of time, or the debt snowballs as it did in the mattress example. After the introductory period, any remaining balance is usually subject to a pretty hefty interest rate, that compounds, or gets charged based on the amount you owe, plus any interest owed, each month. The minimum payment that the credit card company requires will never cover all of the interest and the amount you owe. They are in it to make money. In fact, paying the minimum could make your total debt grow. If at all possible, never carry a balance from one month to the next. If you pay a credit card off every month, you will not be charged interest, and your credit rating will improve over time.
What is Credit Utilization?
Credit utilization can be a term that refers to how much of your credit limit you are actually using, or utilizing. In other words, your current balance relative to the amount you could charge. A credit scoring company, such as FICO, looks negatively on someone who utilizes a high proportion of their credit line and keeps a balance. Credit utilization could also define how you are using your credit to increase your credit score. Utilizing credit in a way that it helps you and does not hurt you could be termed credit utilization. Using credit to pay other long term debts off, such as student loans and mortgage payments increases your credit score. It is improved by having accounts of different types, and paying each as agreed. Be careful that your total debt, both overall (excluding mortgage generally) and monthly does not exceed 1/3 of your income. This is called the debt to income ratio, and plays a large factor in your score. The lower your debt in relation to your income the better. There is a balancing act in how many accounts in good standing is too many or not enough. You want a mix of account types, but be sure your balances on rolling credit, such as credit cards, remains very low. Ideally, 0 each month. On regular loans, paying on time every month and a little extra each payment will add to your credit score.
A Warning from My Own Story
Credit allows you to buy things that you could otherwise not afford to pay for all at once. It should be seen as a tool and a privilege. Good credit can help you to get things such as nice cars and a nice home. Bad credit can affect nearly every aspect of your life. A person with bad credit can lose job opportunities, or be denied housing. In my life, I have been in a predicament where I did not have good credit, because I had let my student loan payments lapse. My partner at the time also had a rental eviction on her record. We could not find a single person to rent to us, and we ended up homeless briefly until a friend took us in. I never want that to happen to you, so please heed my advise. Protect your credit!
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