by Jake Holmes
Within the U.S. financial system, credit is the ability to borrow money to access goods or services, with the understanding that you’ll pay back the funds at a later time. Credit unions, banks, and other lenders issue credit to people who want to obtain something now, but who either can’t or don’t want to pay for it now. Before someone is granted any credit, lenders determine the person’s creditworthiness, or how likely they are to pay the money back in full and on time.
To determine creditworthiness, or how likely someone is to make payments, a financial institution will usually request a credit report from the three main credit bureaus – Experian, TransUnion, and Equifax. Throughout the year, credit unions, banks, credit card issuers, and other lenders report payment history to the bureaus. On-time payments, late payments, purchases, credit limits, and balances owed are all reported. The credit bureaus compile that information to create a credit report that assesses the likelihood that the loan applicant will repay the debt. The information on a credit report helps lenders decide whether or not to grant a loan, and if so, what the interest rate will be.
An interest rate is the amount a lender charges for the use of funds. This is expressed as a percentage of the original loan. Someone with a good credit history is likely to get lower and more favorable interest rates on loans or credit cards – meaning someone with a good credit history will pay less over time than someone with a bad one.
A credit card is an example of revolving credit. With a credit card, there is a maximum borrowing limit, but the bill doesn’t have to be paid in full each month. However, you do need to make the minimum payment, which usually is listed on the statement. If you decide to make a partial payment instead of paying the balance off in full, the remaining balance will carry over to the next month. If you carry debt from one month to another, you can be charged interest. If you pay your balance in full each month, you can avoid paying any interest at all.
For example, let’s say you bought a $1,000 refrigerator with your credit card. We’ll say the interest rate on your credit card is 18% and your minimum monthly payment is 3% of your balance. At 3%, your minimum payment each month would be $30. If you only paid the minimum each month, it would take 93 months to pay off this one charge on the credit card and you would have spent $698.38 in interest alone – for a total of $1,698.38 for the $1,000 refrigerator. If you paid $200 a month, instead of the minimum payment of $30, you could pay off the charge in six months and you would have spent $47.53 in interest – for a total of $1,047.53. If you didn’t carry a balance and simply paid the $1,000 at the first payment due date, you wouldn’t be charged any interest at all.
Understanding credit is incredibly important, as it can help you finance major milestones in your life such as buying a home or a car, or funding your education. Credit reports are often pulled by lenders, landlords, and even employers – meaning credit influences all aspects of your life.