Stories are everywhere about the wonders of credit and its woes as well. Without credit, few people would ever experience home ownership, purchase a vehicle or major appliance, or even attend college.
With personal lines of credit, people have been able to start successful businesses, which is something that’s often not possible without having a large sum of savings in the bank. But credit and its misuse have also sent people deep into debt and even into bankruptcy.
Each year there are over 1 million adults who declare bankruptcy in the United States, and that number is rising.
This lesson introduces or reintroduces our readers to what credit is – and the part it plays in the economy of our country.
We’ll analyze various forms of credit in our society and discuss ways that credit helps people to obtain goods and services without paying for them in full at the time they buy them.
The bottom line: credit is a basic financial tool that must be managed and used responsibly, or it is a dangerous weapon that can cause a good deal of pain.
Dangerous as it can be, credit enables people to obtain and use money that they don’t currently have. Having credit means for many, purchasing an order with a very small down payment or obtaining a mortgage loan to buy a home or condo, or it can allow a student to attend higher education through a college loan. In return for the use of money, the borrower is expected to pay interest and fees, and then repay the original loan amount within a certain period of time.
Interest is what we call the fee paid by the borrower for the use of someone else’s money. The lender extends the credit because it’s a good way to make a profit on money that would have been just laying around. In the win-win situation, the borrower gets to have a better life, and the lender gets to make a profit for lending his money. He is rewarded for having the foresight to save or accumulate money. He puts it to work by lending it to someone who wants or needs it.
People have a range of feelings about borrowing or lending money.
Your goals and values will influence your attitudes about borrowing or lending money. Attitudes range from those who would never use credit to people who absolutely cannot live without credit, to somewhere in between – sensibly using credit only when necessary, or when using money can produce wealth.
Sometimes, some advisers oversimplify. They see many people drowning in credit because they didn’t exercise self-control and borrowed so much and accepted very difficult terms. So, those advisers tell people that debt is evil and dangerous. They suggest cutting up your credit cards and completely staying away from debt no matter what.
Actually, credit is a wonderful invention when used correctly. A good rule of thumb would be to borrow money for the purpose of making more money.
In modern society, a car is an important tool. It saves you the only real valuable asset you have in the world, time. Spending hours taking buses only reduces your earning power. That means that borrowing the money to buy a car, so that you can commute quickly and conveniently to work makes great sense, as long as your job pays enough to easily handle the car payments.
Borrowing money makes perfect sense when that money is used to buy a rental property, or to do something that generates income. Most wealthy people got that way by using other people’s money to acquire profitable assets.
On the other hand, it makes very little sense to borrow money for drapes and fancy furniture, causing the borrower to have to pay interest that accumulates. That money, that is being used to pay the interest, could have been saved and that borrower could have been accumulating that money for investment.
The pros of credit –
1. credit makes it possible to buy and enjoy expensive items while still paying for them.
2. It provides convenience when traveling and for purchasing by mail or the Internet.
3. It also facilitates the handling of financial emergencies.
The cons of credit –
1. Purchases cost more because interest and fees are added to the price of the purchase.
2. Consumers are often tempted to overspend because available credit gives them a false sense of security. The result is often a poor credit rating which makes borrowing more expensive in the future. Also, you are committing your future earnings, and you may be still paying for your long after the benefits have expired.
3. People who have already borrowed too much, have weakened their own bargaining positions, and often must accept very bad terms including high interest rates. Lenders who prey on people in credit trouble often pack the loans with unneeded extras and misrepresent critical loan details.
As an educated consumer, it is a good idea to look around you and notice how much of the advertising you see every day is designed to induce you to buy things you can’t afford, and to tempt you to borrow money to get those things.
Poor people watch the people with money. They want to emulate those they consider rich, and they want to be like them, so they can feel better about themselves. They see “rich” people with a lot of stuff, so they want to buy a lot of stuff too, hoping to feel better about themselves.
The truth is, those who actually become rich often do so by avoiding buying a lot of unnecessary stuff, choosing instead to put their money to work on income producing investments.
After they have acquired enough income producing investments, such as businesses, rental properties and stocks and bonds, they are able to use the income from those investors to buy cool possessions.
In other words, the smartest thing we can do is to avoid being tempted by the need for self esteem.
Instead of buying a lot of consumer goods, let’s save up and buy income producing investments. In a great economy like we have here in America, it won’t take you long to produce real wealth by demonstrating a little discipline and putting your money to work.
This article is written in the hopes of presenting inexperienced but well-meaning readers from getting themselves into credit trouble through lack of information.
The following are some of the words we use to talk about credit, and their definitions.
Next time, we’ll discuss how to shop for the best credit terms, when you choose to use this valuable tool.
annual percentage rate (APR) A rate that shows the total cost of credit annually. It includes a percentage of the principal as interest on a loan plus other costs (e.g., points on a mortgage loan, service charges).
capital The amount of monetary resources a potential buyer and/or loan applicant has available. A measure of creditworthiness.
character A person’s willingness to repay a debt. A character loan is based on the reputation and/or personal credit history of a borrower, rather than collateral. A measure of creditworthiness.
collateral An asset such as an automobile or a piece of property that a person uses when taking out a loan, promising to give the asset to-the lender if loan payments cannot be met.
credit The borrowing capacity of an individual or company. A transaction in which a borrower (or debtor) receives goods, services, or cash and agrees to repay the lender at a future date, normally with interest.
creditor The lender or supplier of money, goods, services, or securities.
debit card A card used for purchases that is issued by the consumer’s bank. Funds are deducted from the consumer’s checking account and transferred electronically to the merchant’s bank account when a purchase is made.
depreciation A loss or decrease in value, especially because of wear or age (e.g., the depreciation of a new auto).
finance charge The cost of credit, including interest paid by a customer or a consumer for a consumer loan. Under the Truth in Lending Act, the finance charge must be disclosed to the customer in writing.
installment credit Credit that is granted for purchase of durable goods, on condition of its repayment at regular intervals over a specified period of time until paid in full (e.g., for an automobile or home). The seller retains legal title to goods until the last installment is paid.
installment loan A loan, extended by a financial institution or retail firm, to be repaid with interest charges in installments over a fixed period of time. Example: student loans.
interest An amount of money paid for using funds over a period of time, generally an annual percentage rate. Bank interest is both an amount paid to depositors of funds and a finance charge for money that is borrowed.
predatory lending Fraudulent, unethical, discriminatory, or abusive lending practices designed to exploit vulnerable borrowers and lead to their increased indebtedness (e.g., excessive and disguised fees for home mortgages).
principal The original sum borrowed.
revolving credit System of retail credit (e.g., department store or bank credit cards) in which buyers make periodic payments on purchases and service charges. The service charge is based on the outstanding balance; if the buyer pays the entire balance, no service charge accrues.
secured loan A loan which is backed by the borrower’s assets, when the borrower’s credit rating is not strong enough to justify an unsecured loan (not backed by the borrower’s assets). The assets may be forfeited to the lender if the borrower fails to make the necessary payments.
three C’s of credit Creditworthiness is measured by three factors, sometimes called the three C’s of credit character, collateral, and capacity (see definitions above).
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