The Basics of Credit

You might think that a credit is a modern phenomenon, but people have been using credit long before credit cards. Let’s take a moment to learn the basics of credit.

What is credit?

Each and every day, individuals and businesses are purchasing goods and services on credit. This includes everything from new shoes or legal advice to airline tickets or the construction of an office building.

Credit allows the buyer to purchase an item with the promise of paying it back. They also have the option to pay a partial monthly payment coupled with an added charge for the convenience, time, and use of the money. Some people are naturally extra careful with their money while others spend thoughtlessly.

But the ability to manage your money better is a skill that EVERYONE can learn.

Credit is not a new concept

Local general stores, as well as large department stores, have allowed customers to purchase goods on credit for more than 100 years. Then, as now, a person’s ability to pay what they owed in a timely fashion determined whether or not they were able to continue to use credit to make purchases.

Today almost everyone uses credit in one form or another for everything from emergencies to situations where it makes more sense to use a credit card instead of cash.

Reasons for a person to have a credit card include:

• They may not like to carry cash
• Monthly statements are used to help itemize budget expenses
• To benefit from a rewards program for additional goods, services, and discounts
• Simplify for convenience

Your credit history

Using credit to your advantage is one way you can build and improve your credit history and score. It is also a way to get the things you need now and in the future without having to pay the entire cost upfront.

However, using credit recklessly can be one of the easiest traps to fall into to destroy your credit reputation and financial well-being.

When it comes to establishing credit via an application process, there are a number of “hoops” that you will be required to jump through. Expect to address your financial situation which includes the following:

• Most credit card companies require the cardholder to be 21 – unless, you are on a joint account with an adult.
• Your Social Security number
• Basic information about any sources of income
• Expect questions about your housing situation – including the length of time you have been at your residence

Important: When you sign and date a credit card application you are completing a legal document stating you will follow the guidelines for borrowing and repayment set out by the credit company.

What questions to expect

Your credit history is also checked via your Social Security number to determine whether or not to provide you with credit along with a recommendation of how much credit is available to you.

Obviously, the credit card company uses this information to evaluate the risk your borrowing poses to them. Other questions they consider are whether or not you are an individual that:

• Uses credit consistently and pays off the full amount each month?
• Only pays the minimum amount each month on your credit bills?
• Jumps from one credit card to another to transfer amounts you owe in hopes of postponing paying more than a minimum payment?
• Racks up a lot of interest by skipping payments or paying a minimum amount each month?
• Plans to charge everything you want hoping there will be some way some time you can pay it off in the distant future—or declare bankruptcy and try to get out of ever paying off your loans?

Tip: All of these behaviors build your credit history, resulting in a number score that can determine how you are assessed in a lot of different situations.

Credit and loans

In some credit situations, you may be asked to disclose any collateral or items of value you own that can be possessed by the lender in case you default on the loan. For auto loans, this can simply be the title of the car you are financing.

If you don’t pay off the loan, the financier can retain the title and repossess the car.

Secured loans often get approved more quickly and may also be obtained for lower interest rates. It is even possible to overcome bad credit if you are able to provide collateral for a secured loan.

Importance of debt-to-income ratio

If you are trying to maintain a good credit history and use debt wisely, you’ll need to figure out your debt-to-income ratio (DTI) on a monthly or yearly basis.

Most lenders also are interested in this number as it applies to your ability to make good on the credit you are issued.

You can calculate your DTI by adding up all of your monthly expenses and bills, including credit card and other loan payments, and divide it by your gross monthly income. This score is a percentage with a lower score being preferential in most cases.

So how do you know what is a good DTI? Each lender has different guidelines used in evaluating potential credit customers.

In some cases, the lender will want you to exclude mortgage payments or even student loan payments in your calculation.

Tip: Overall, if your DTI  is less than 35%, you are considered a likely candidate for being able to pay back any additional loans or credit.

More than a 50% DTI may be an obstacle to obtaining a loan or additional credit.

Your DTI is a number you should be familiar with if you are interested in buying a big-ticket item on credit as well as if you are simply interested in improving your overall budget, future opportunities, and personal money management.

Additional consideration

Knowing your credit history and DTI numbers as well as other details about the use of credit can be important if you are interested in understanding how you handle your finances and would like to concentrate on achieving your fiscal goals.

There is much more to consider such as details about your credit score, the different types of credit cards and their uses, loans versus credit, and whether or not there really is such a good thing as good debt and bad debt. For example:

• Do you use debit and credit cards in a way that helps you control or at least know about your spending?
• Is it worth it to save 20% on a purchase by opening a store or special credit card?
• Are there ways to reduce your debts that could maximize your ability to have the goods and services you want along with peace of mind that you are on the path to a more secure financial future?

Keep those questions and any others you have in mind as you continue to learn about credit.