Understanding credit

Credit is a way of buying now and paying for the purchase at a later date. Think of credit as debt, money owed to someone else. The use of credit involves the consumer paying fees to use someone else’s money. The common type of fee is called interest. The interest is due periodically along with a minimum principal payment amount. This is how the company or person making the credit available to the consumer makes money.

Credit history

The concept of credit is not new. Credit has been used for centuries but not obviously via swiping on a card machine. In the old days, people felt comfortable lending money to select individual locally. Basically, the decision to lend or not lend was primarily based on whether or not the person making the loan personally knew the individual seeking the loan. Think of town where everyone knew everyone else. The storeowners and other creditors would lend to their customers living in the town, but not to strangers.

As towns became cities and as cities grew and as it was possible for people to move quickly with modern transportation, there was a need to come up with a new way of extending credit. The new way of extending credit to consumers was based on prior credit information reported to the major consumer reporting agencies. With the introduction of this system, it was no longer necessary that the creditor needed prior credit relationship with the customer. In the United States, credit is no longer based on whether or not the creditor knows the customer.

Think of the last time you used your credit card. The chances are you bought the item with your signatures and without speaking with anyone from the credit card company. When you apply for a credit card, it is not even necessary for you to speak with the credit card company. This all be can done via mail or online. So you hardly get any chance to introduce yourself to the creditor!

Uses of credit

Consumers use credit in number of ways but most commonly in the form of loans and credit cards. Here are number of examples of use of credit:

  • Buying a home
  • Buying a car
  • To pay for car repairs
  • Paying for college tuition and other educational or job training expenses
  • Traveling or taking a vacation
  • Shopping

But why do people use credit given that they are taking a debt? There are number of reasons:

  • People don’t have enough money saved to make a purchase. Think of buying a home. Most people need to get a loan (mortgage) to purchase a home. This is also true when buying a car, boat, or other expensive assets.
  • Credit provides a convenient way to get access to money to respond to an emergency such as hospital bill.
  • Carrying cash is not safe especially when traveling. Cash can be stolen or lost. If you loose a credit card or if it is stolen, you can get a new one (after you request the old one to be cancelled). Spending cash also leaves you with handling loose change and manual labor to track how you spent your money. By using a credit card, you have access to your statements to know how you spent your money.
  • When taking a rental car or hotel room, credit card is required.
  • If you are shopping over the internet, you are likely to pay with a credit card, as opposed to using cash or banking account.
  • Paying with credit card earns the consumer some reward programs that can be redeemed for gift cards, cash, merchandise, or travel.

As you see above there are number of reasons why credit is used. But most often the need for use of credit boils down to the fact that the consumer does not have enough cash saved to pay for the purchase. For some purchases, for instance, saving to buy a home would take a very long time for most people. Credit is the answer in this case. But consumers should not use credit just because it is available to them. Instead credit should be used in cases where the purchased items (or assets) will last a long time. Buying a home, car, or boat, and getting education are nice examples of using credit.

Repeated use of credit for these purchases should be avoided (particularly if the credit card bill is not paid in full by the due date every time):

  • Buying lunch or dinner
  • Buying grocery
  • Paying other bills with a credit card
  • Buying books or magazines
  • Buying gas for a car
  • Buying lottery tickets
  • Paying for parking

By no means is this a full list and it probably does not apply to everyone. The point, however, behind showing these purchase examples is that what is purchased does not last very long. Consequently, buying these items repeatedly with credit increases the debt load. Instead, consumers should consider using cash or bank card.

Posted on 4/4/2008
by Raj Singh