I have three growing kids, two in college and one in high school. Watching them growing up and being educated by the public and private schools in the US, I realize that our schools have not taught them the necessary concepts and frameworks to make sound financial decision in the real world.
That gets me worried.
In this series, I share the notes that I used to talk to them about money.
First I am focusing on credit.
What is Credit?
Credit is other people’s willingness to let you use their money that you will repay some time in the future. It is a privilege, not a right. By “other people”, I mean banks, credit unions, credit card companies, or even your relatives (parents, for example).
“Credit” can be used inter-changeably with “loan”.
How do you earn credit?
To earn the trust of the “other people”, you need to demonstrate you can borrow money and pay back on time. As stated in the good old book: “Whoever can be trusted with very little can also be trusted with much, and whoever is dishonest with very little will also be dishonest with much.” (Luke 16:10)
What are the types of credit?
Categorized by how the credit is extended and how it is paid back, credit falls into the following three categories:
Installment Loan: require regular payments, usually monthly, until the principal is paid off. Car loans, student loans, and mortgage all fall in this category.
Revolving Credit: includes bank credit cards, store credit cards, and home equity line of credit. You are required to pay at least the minimum payment by the due date. You can pay the minimum amount, the full payment or anything in-between. You can keep using the credit as long as you pay the minimum and stay within the credit limit.
Service Credit: used for monthly utility bills, such as electricity, gas, and yes, your cell phone bills. You set up an account, use a service and get billed by the service provider.
What Are the Advantages of Credit
- You can get instant gratification, “buy now and pay later”;
- Usually, no interest is charged when credit card bills are paid in full by due date;
- Credit cards are safer to carry around than large sum of cash around;
- Keep record of how you spend money so you can analyze your spending habit;
- Some credit cards offer “bonuses” such as cash back or frequent flyer miles.
What Are the Disadvantages of Credit
- You can forget how much money you have spent and lead to overspending
- Interest costs can be very high. How high? 15-20% for unpaid credit card balance is very common.
- If you only pay the minimum each month, then the pay-off period will extend to very long
- Since you owe so much money to other people already, you may not have much buying power left in the future
What is a Credit Report?
Lenders do not take your word for it when they come to determine whether to extend credit to you, instead they pull your “credit report”. It is kind of like your “school report” but lists different things. It describes your past use of credit, such as being on time in paying back debt, types of credit accounts opened, number of loans applied for, and the amount of outstanding balances.
Three companies, called credit bureaus, gather information about you and give it to lenders. These three companies are:
You can order you credit report once a year to check for errors or see if your identity has been stolen. Following the directions that come with the report, you can fix the errors.
What are Credit Scores?
Sometimes referred as a FICO score, a credit score is a three digit number that describe your trustworthiness, or your future bill-paying behavior. It ranges from 300 to 850. It reminds you of your SAT scores? Fortunately, you can have a low SAT score but achieve a high credit score. Lenders look that the number and decide whether to give you a loan, or if they do, on what terms (interest rate, down payments, etc.).
These factors affect your credit score:
- Previous payment history
- Amount money owed
- Number of recent credit inquiries
- Length of credit history
In conclusion, you should be smart to build, use and maintain your credit-worthiness.