It seems like everything is put on credit these days. From lunch and movie tickets to paying for a college degree, consumers are living on borrowed money. Governments are also relying on credit to keep their doors open, and businesses are receiving credit to expand into different markets.
What is Credit?
Credit is when a borrower receives something now and contractually agrees to repay the lender at a specified date with interest (extra money charged on the loan). When a person borrows money, they go into debt, as the loan must be repaid, usually with the addition of interest charges.
The four most common types of credit are:
- Revolving: You are given a maximum borrowing limit and you can make transactions up to that limit (credit cards).
- Charge Card: You are extended a borrowing limit, but it must be repaid in full every month.
- Service Credit: You receive services from utilities, cable companies, and cell phone providers with the understanding that you pay them after the fact.
- Installment: You are approved for a lump sum loan that you agree to repay, plus interest and other fees (this is often used for student loans or auto loans).
The industry uses credit scores and reports to gauge your creditworthiness – that is, lenders will look at your past credit activity to see whether you have been reliable in paying back borrowed money. A stable credit history will encourage lenders to loan you money, while a history of failing to repay loans will make lenders judge you as a risky investment.
How Credit Works in Finance
Credit goes beyond just tapping your credit card at the local coffee shop.
Credit plays a huge role in financial markets. On Wall Street, companies and governments sell their debt to investors. The purpose of issuing debt securities is to raise capital (money) now and pay interest later.
Just how enormous is the credit market? To put it into context, a recent study found that if all borrowing ceased, gross domestic product (GDP) per capita – a measurement of economic growth divided by the population – would be wiped out in America. But this is not only an American phenomenon. The rest of the world is depending on credit, too, and using savings and investments to purchase goods and services has become a relic of the past.
The Dangers and Benefits of Credit
While credit can be convenient when you are short on cash, one of the more common risks of gaining access to credit markets is that you might borrow more than you can afford to repay. You might be given more credit than you need, which could enable you to spend more than you planned.
Another common scenario for consumers and businesses is that if they fail to make payments on time, then their credit records will take a hit. In addition, they will lose money on late fees and other charges listed in the terms and conditions of agreements.
But is all credit bad? Not at all. If used responsibly, credit can be a productive tool.
By using credit, you may be able to invest in a new startup business or purchase a house or an automobile. Credit allows you the flexibility to make major purchases that could positively affect your opportunities, especially when they are expensive, such as a new computer a student loan.
If you are a responsible borrower – you repay the principal amount (the amount borrowed), pay your bills on time, and cover any interest you owe – then a good credit history makes your life a lot easier. You can obtain better rates on services and your rental application for an apartment has a better chance of being accepted.
Overall, your life is so much easier when you have a good credit score and you are taking advantage of credit the right way. That is why they say there is good debt (mortgage, education, or a business) and bad debt (apparel, clothes, or a television).