Understanding Credit

Understanding Credit

We live in a society that relies heavily on credit. How many of us really understand loans, mortgages, refinancing, and more commonly, how many of us really have a full grasp of understanding credit cards?

In order for us to understand the world of credit, we first have to understand the real meaning of the word credit.

Defined, credit is a term used to describe a lending of something, in the expectation of it being returned. When used in financial terms, let’s be very clear, that using credit is borrowing money.

It takes many different forms, for example personal loans, overdrafts, and credit cards are all forms of credit, but in essence all of them involve you the consumer borrowing money from the lender, with the obligation to pay it back in full.

Of course in today’s modern world where money can be short, but the temptation if spending is high, there is always a danger of being drawn into the cycle of borrowing, and spending money that you do not really have a chance of paying back, and it is this sort of borrowing and lending that some blame for the recent worldwide economic problems.

The Different Types of Credit

When it comes to understanding credit cards, loans, mortgages etc, it can be very confusing to someone entering the financial world.

There are Internet, television, and billboard advertising all offering many different financial products that will give us more money, and more financial freedom, but it is vital that we fully understand each type of credit we are getting involved with, understand what our obligations are, what the lenders obligations are, and of course a clear understanding of our own financial position.

The first and probably most important thing to be aware of when you look at any sort of credit, is that you are borrowing money.

When you take out any sort of credit agreement you have to sign an official legal document obligating you to repay the loan in whatever form it takes. Of course the lender also has responsibilities under the contract, but it is vital you are aware you are signing a legal contract so it is not something that can, or should be taken lightly.

Why do Lenders Lend?

What is in it for lenders? What do they get out of lending you money and you paying it back to them? What they get is a term you will hear all the time in the credit world and that is, interest.

When you borrow from a lender, depending on the type of credit, you will either pay the borrowed amount back over a fixed term, or it will be a rolling debt. In either of these cases you will be charged extra each year on the amount you borrowed.

The extra amount you are charged each year is normally taken in the form of a percentage of the original amount borrowed. This is known as the Interest Rate.

For example, if you borrow $1000 from Bank A, and their annual interest rate is 10%, then each year you would have 10% of your outstanding balance added to your total amount owed. So in this case if you borrowed $1000 then at a interest rate of 10%, you would incur a $100 interest charge on your owed amount in the first year.

This is a very basic example and some banks work out interest charges monthly, and in some cases even daily so the figures used are not a direct representation of what you will be charged, but gives you an understanding of what interest actually is.

The Longer you Take to Pay, the More they Make

Because of the way interest works, the longer it takes you to pay off a loan, the longer the lender will have to charge you interest, and of course the more profit they will make from you.

That is why you will often be advised with whatever kind of credit you are taking, to try and pay the balance as quickly as possible. This will limit the amount of interest you have to pay in the long term.

Types of Interest

There are several different types of interest you will encounter on your financial travels, and here we look at some of the most common and explain how each one works.

Fixed Rate Interest- This is a set percentage of interest that is agreed between lender and borrower at the start of the loan, and is permanent. This means that regardless of whether interest rates go up or down, the rate you pay will always remain the same.

Variable Rate- This kind of interest is generally linked to inflation and interest rates, and so will go up or down depending on global financial situations.

This kind of interest does not give you the stability that a fixed rate interest deal will, but will let you benefit from any fall in interest rates that occur. Of course be aware that as much as interest rates can fall, they can also increase which will mean you paying more each month.

Interest Free Days- This kind of interest deal is more commonly associated with credit cards, and when you grasp the concept of interest free days, it will greatly help you with understanding credit cards.

Interest free days give you a period between the time of purchase, and the time when the lender begins charging you interest on that amount.

If your credit card lender gives you 30 days interest free on your purchases then if you buy a new pair of shoes on day 1, then you will have until day 30 to pay the borrowed amount off before you start having to pay back interest.

This can be a very convenient way to make purchases and pay them off over a short period of time.

Understanding Credit Cards

Possibly one of the most common and popular forms of credit today is the credit card. This is also one of the most obvious routes to peoples financial downfalls, and it is simply due to a lack of understanding credit cards and how they really work.

When you are given a credit card you will be given an agreed credit limit. This is the maximum amount you can borrow on your card account. So if for example you have a credit limit of $2000, that means you will only be able to spend up to $2000, before you have to repay some of the balance in order to free up more funds.

You will also be given an agreed interest rate. Be aware that many credit card companies offer very attractive promotional rates of interest to bring in new business, however these low rates are not always permanent, and are likely to increase, so you must be certain you have a full understanding of the credit cards interest rate, and what you have to pay back.

Penalty Charges

Some credit card lenders will charge you a penalty if you go over your agreed credit limit, or if you fail to make a payment on time.

Make sure you understand exactly when your credit card bill is due, and try to make sure there is money available to make the payment so you avoid being charged extra. Also be aware that any late payments, or defaults will affect your ability to gain credit in the future.

Do not Spend More Than You Can Pay Back

As tempting as it can be to go out and spend your full credit card limit on a new computer, or whole new wardrobe, it is vital that you make sure you have the facility to repay the debt.

Many people make the mistake of taking on a credit card, without properly understanding whether they can afford to pay back the loan.

Credit cards are not a means to free money, but just a convenient way to pay for things. The key is to remember at all times that each time you buy something using your credit card you are borrowing a sum of money that must be paid back.

Not All Doom and Gloom

As scary as some of that may sound, credit in all it’s forms can be very useful, and if used responsibly can make our lives easier in many ways.

The best advice is, if you are taking out a home loan, read, learn and have a good understanding of home loans. If you are getting a credit card, make sure you read, and research what you are taking on.

Understanding credit cards, store cards, home loans, and all other forms of credit are vital to how successful you will be in your financial life.