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Credit 101

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With all the talk of credit these days, it’s important to keep a perspective of what it all really means to the average person. Credit, derived from the Latin word, “cred,”  translates to belief or trust. Simply stated, credit is the ability of a customer to obtain goods or services before payment, based on the belief or trust from the lender that payment will be made in the future. Credit always comes with the price of accruing interest, so consumers always need to decide how they want to use their credit and determine if something is a “good” debt to own.

Debt is the flipside of credit. Household debt can be defined as the total debt owed by all members of the household, including mortgages and consumer debt. While a business loan which could potentially improve your financial situation, or a home loan, which is normally considered an appreciating asset, may typically be considered “good debts,” much of consumer debt is thought to belong in the “bad debt” category.  These debts are acquired through the purchase of goods that are consumable, meaning they have little to no appreciation and most likely depreciate in their value (like vehicles, clothing, entertainment, etc.).

Like it or not, credit has become a staple to the American lifestyle.  Trustworthiness to pay back which that which is borrowed may be more important now more than ever to ensure the health of the economy, and the financial well-being of the consumer. With that in mind, with increases in credit card debt, auto and student loans, and new mortgages, American consumer debt now stands in excess of $12.58 trillion dollars. So, why are people using debt now more than ever, and what changes if any are needed?

Why People Choose Credit

It is nearly impossible today to make it through the usual social milestones of life without having to rely on some type of credit. From credit cards, store cards, car loans, personal loans, student loans, and home mortgages there is no shortage for the use of credit. Most young adults will be advised that to build financial integrity and be able to qualify for loans, they need to start “building their credit,” so that institutions can decide if they are trustworthy enough to lend to.

Using information from a person’s credit history, creditors use a mathematical credit scoring model that computes the probability of the applicant being a good credit risk. This becomes a financial profile used to compare the individual to others of the same profile to determine how much of a credit risk they would pose. If the risk profile shows that they are a high risk, they may be denied credit. The irony is that they may also be denied credit if they have no profile – thus, no debt.

With no lack of opportunities for people to build credit, from the bombardment of credit card offers in the mail along to the constant prodding to apply for a store credit card at nearly every checkout stand, many see using credit cards or applying for loans, just the price to pay in today’s economic world. Consequently, most young adults find themselves stepping into complex world of personal finance, trying to find the balance of obtaining credit and paying off that which is owed.

The Problem with Credit

While the lure of easy credit is appealing, without discipline if can literally come at a very heavy price. Since credit expands a person’s purchasing power, allowing him or her to buy something immediately without any cash, the temptation is to purchase something on credit that cannot be paid for at the end of the billing cycle, or to make payments on a loan for something that ties up their money and, consequently, their ability to save or invest. Since interest never sleeps, paying the minimum payment on a credit card bill or loan payment can result in a much larger purchase price for the item(s) than initially expected. To see just how long it will take to pay off your credit card, use a minimum payment credit card calculator to get an idea of how it all adds up.

Because of the potential for a large payout in interest, the issuing of credit has become a very large business. With store promotions, tempting balance transfer options, and low introductory interest rate offers, banks, credit unions, and merchants compete vigorously to get consumers to use their credit cards and services. The marketing is so aggressive that consumers may lose sight of the fact that credit is not free money, and this can lead to spending beyond their means by making excessive purchases.  If the ratio of debt to income becomes out of balance, financial hardship is always the result with a possible path towards bankruptcy.

Credit Must be Used Cautiously

While using and extending credit may initially benefit both the buyer and the lender, if borrowers can’t make their payments the flow of credit can slow or stop, and that can hurt both the consumer and the economy. Because of this, credit must be obtained and issued judiciously. This makes financial prudence and temperance on both sides essential.

Credit should never be used to make impulse purchases. Keeping in mind that consumables, are well, consumable, it is wise to use a cash only method of payment. That way a person will avoid paying a finance fee and interest on something that is disposable or losing value. Costs for clothing, food, entertainment and other everyday items should be a part of a well-planned budget, instead of being acquired through credit.

Keep in mind that there is a large gap between the protections and risks for the debtor versus that of the creditor. Creditors usually have measures in place to protect themselves from the poor judgements of debtors, but would be debtors must rely on their will-power and financial prudence to protect themselves from an over extension of the credit offered from the lender.  Because creditors often view the potential for a high rate of return worth the risk of issuing credit, creditors are likely to take more risk than the average investor can afford. Consumers should always look at the total cost of borrowing from an institution, or purchasing on credit, before deciding to acquire the debt.

While credit is an important financial tool for both the consumer and the lender, it is also one that should be entered in with caution. The tendency for people to spend more than they can afford, combined with the aggressive targeting and lending practices of businesses and other financial institutions can make for a volatile situation. However, through proper education, financial savvy consumers can use credit to invest in themselves through building a business or acquiring appreciating assets.