Before anyone can even hope to use credit properly it’s important to know exactly what it is.
The answer to that is simple: most people don’t truly understand what credit actually is and how it works.
That leads to it being among the top reasons people get into financial trouble.
More specifically, consumer debt such as credit one of the biggest causes of bankruptcy.
In fact, credit debt (or living above one’s means) falls behind only medical expenses and job loss/reduction of income as the leading reason people file for bankruptcy.
So you can see why it’s so important to have a firm understanding of credit to stay out of financial trouble.
What Credit Isn’t
The first thing people fail to understand is that credit isn’t “free money”.
When you get a credit card, you aren’t being given the credit line to do with as you please with no expectation of repayment or penalty for failure to repay.
As you can see in the image above, the credit card statements state that repayment is necessary and if you don’t pay it all back or pay it late then you are charged interest and late fees.
The same holds true for all other forms of credit for which the more common forms include:
- personal lines of credit
- car loans
- Home Equity Line of Credit (HELOC)
- store charge cards
- borrowing money from a friend.
The intent is that when you borrow money, no matter the form, purpose, or length of time you are indeed borrowing it.
What Credit Is
First, let’s start with the official monetary definition of credit as provided by Oxford:
- the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.
I’ve got unlimited credit
- the money lent or made available under a credit arrangement.
The bank refused to extend their credit
Pay very close attention to the part that reads: payment will be made in the future!
It may be only a few words but it’s the basis of everything regarding credit and where people screw up the most.
Now let’s talk about credit in the everyday sense.
Credit Is A Tool
That’s the simplest explanation!
For some people it’s a way to simplify their finances by having everything charged to a credit card so they condense as much as they can into a single payment.
For others, using a credit card is a way to get discounts in the form of cash back on the things they normally spend on.
Still others use it as a way to keep their cash working for them in the stock market or high-yielding accounts like savings or CDs like with a home mortgage.
Credit is a tool no different than a hammer, food or your vehicle.
As with any tool, if you use it wrong it can cause you problems:
- If you a manner carelessly you can smash your thumb
- If you eat poorly, you can gain unwanted weight
- If you don’t pay attention when driving, you can damage your own vehicle or someone else’s property
And if you misuse credit you may end up with a home in foreclosure or mountains of credit card debt.
Just to reiterate the most important point:
Credit is not free money!
Once you get that fact drilled into your head, your relationship with credit should be a lot easier to manage.
And when you understand this combined with the different types of credit that exist you will be in a better position to use it as the valuable tool it can be!
Questions For You
What is your position on credit–are you a credit user or a cash-only, anti-credit person? Does your position come from personal experience or just based on what someone else has said?