Credit - Part 1

Series on Banking

Here at Finance OneforOne, we think that understanding banking is an essential component of financial literacy. Banking is a general term used to describe the variety of services offered by banks. Our article series will cover everything from checking accounts to loans.

Credit

At least once in your life, you heard of the word “credit.” It is one of the most essential banking services and financial literacy concepts. As you will learn, understanding and maintaining credit creates many opportunities for you.

What is credit?

In banking and finance, credit is an agreement between you and the bank on a loan. Any type of loan—mortgage, auto loan, anything—is credit. But when we say “credit,” most of the time, we refer to credit cards.

Credit cards

This is what credit cards look like. As you can see most of them are facilitated either Visa or Master Card, but there are other facilitators such as Discover and American Express.

Let’s say the bank agrees to loan you $5,000 each month. Unlike a traditional loan, you don’t get the entire amount and pay it back with interest. Instead, you get a card—a credit card—that you can spend on anything up to $5,000 (essentially, a credit card is like a debit card with money that’s not yours). This way, you would only spend as much you need and pay how much you spent back to the bank.

How much do you actually need to pay back?

This question doesn’t have a definite answer; it depends on your priorities. There is a thing called “minimum payment” that comes with credit cards. This is a fraction of how much you spend, and it increases as you spend more. You need to pay at least this amount every month, however, you will also pay interest. If you prefer to pay as much as you need to and still pay an extra amount, then this is the better option for you. The amount you don’t pay is carried over to your next payment period. Your other option is to pay back the amount you spend fully. This will cover all of the balance (debt) you have on your credit card and not leave you with any liabilities. The latter is clearly a better option for financial independence, but the former allows for more flexibility.

Pros and Cons of Credit

Like most banking services, credit cards have more pros that outweigh the cons. With credit from a bank, you not only create a credit history for yourself (will be discussed in the next article) but also get access to rewards and an opportunity to improve your spending habits. For example, the bank may offer you 200 free miles of air travel if you spend $1,000 with your credit card. Like a debit card, a credit card is protected by your bank, and if it is stolen or lost, you can contact the bank to request to deactivate it and send a new one. With so many advantages, credit cards also come with their disadvantages. The most important of them, as previously mentioned in this article, is the interest rate (and sometimes, fees) that happen each month. Lastly, since the money you spend with credit cards is not yours, you might spend over the amount you are allowed to. To not let this happen, make sure you know about essential income management habits. Finance OneforOne educates about this through its one-on-one sessions, articles such as this, and free online resources!

“Credit - Part 2” will focus on credit history and the importance of good credit!