Maintaining a strong credit history can be one of the most difficult lifetime challenges for people; especially young people just starting out. The paradox most people face is being able to establish credit without established credit! A good first step is to apply for a credit card with requirements that are easy to meet. Credit cards are useful financial tools and a great way to establish credit – but used improperly, they can be an easy way to rack up a lot of debt. Before you dive in to the world of credit cards, it’s important to understand credit-related terms, what they mean and how they help or hinder a person’s individual situation.
What is Credit?
Credit is referred to as a specific amount of money that is made available to be borrowed by an individual. Credit must be paid back to the lender (in this case, the bank) sometime in the future. In short, credit allows an individual to purchase goods or services without having to have “actual” money at the time of purchase. The amount of credit a bank will grant a person varies, depending on individual circumstances like credit history/score, existing debt (credit card balances, school and other types of loans, etc.) and reliable employment, to name a few.
Lesson: Establishing credit is necessary and should be handled as carefully as one’s reputation.
What is an Interest Rate?
An An interest rate is quite simply a fee paid by the credit card holder, for the privilege of borrowing money that would otherwise take time to accrue. Many banks offer an interest-free period for new credit card holders (usually 12 or 18 months) that give the borrower a bit of relief on the balance. After that time, interest will start to accrue on the credit card balance unless the balance is paid off in full every month.
Lesson: Look for promotional, interest-free offers, but keep the potential accumulation of interest costs top-of-mind, especially during this interest-free period, to avoid unpleasant surprises and unplanned expenses.
What Determines the Interest Rate on Your Credit Card?
Many banks have a range of interest rates that are assigned to a specific borrower. The primary factor banks use to determine the interest rate that is assigned to a credit card is an individual’s credit score. What’s in a number? Well, a lot, actually. A credit score tells the bank a lot about a person; for instance how much debt already exists, how timely payments are made, if the person has ever defaulted on an obligation or filed for bankruptcy, how much credit is available to the borrower already, etc. In simplistic terms, the lower the credit score, the higher the interest rate and vice-versa.
Lesson: The decision to default on a school loan or to make late payments on credit card balances or other financial obligations can haunt you for years. Think twice before you decide to take the trip to the Bahamas instead of taking care of financial obligations.
How do credit cards work?
A credit card is used as a form of payment and should NOT be thought of as free money. Each time a credit card is used, an individual is borrowing money, which must be repaid in the future. Most bank credit cards require only a minimum payment of the total balance to be paid monthly; however, unless there is an “interest free” period, interest will accumulate on the balance due.
Lesson: In order to obtain and maintain a strong credit profile, it is important to always pay credit card balances on time and to not over-extend credit limits.
Buying a home, purchasing a car, attending college, preparing for a wedding, and even taking a vacation may require credit. Establishing credit is necessary for most people and provides the flexibility needed to attain goals. The lesson to remember is that our actions and choices impact and shape our credit future.
If you found this article useful, be sure to check out these related articles:
Credit Scores: GPAs for Adults
True or False? Five Myths about Credit Scores Unveiled
Home Equity Loan or Home Equity Line of Credit?