One of the biggest things I hear millennials talk about not learning in school is understanding credit and how to use it. Well thankfully I have come today to shine light on this problem. If you are confused about what credit is and how to use it then this is the post for you.
What is Credit?
Credit is when you get a good or service with the promise that you will pay it in the future.
What does that mean and how does it work
This means that when you wanted to buy an item such as a car in the past and didn’t have the money you would have to save up until you could purchase it. With the invention of credit all of that changes. Now you can pay for that car later (usually in monthly payments). The catch 22 though is there is interest that gets tacked onto the amount your borrowing.
What is an interest rate?
An interest rate is the percentage of return the lender of the money gets back each year. Let me give you an example. Lets say that you borrowed $1,000 for a car on a 60 month loan with 5 percent interest. That means you will need to pay $16.67 per month plus an extra $4.17 for the interest. The $4.17 per month is the return the bank is making on your loan. Check out http://www.investopedia.com/articles/01/061301.asp to see another post on interest rates
When do I pay the money back?
There are lots of different types of credit that you can get but I will cover the basics. First off, with a credit card you receive an interest rate on items purchased. There is no time frame on when you have to exactly pay it off but every month you still have a balance the credit card company is taking a percent out of that total for them. The only thing is you have to pay the minimum every month which is different for each lending company. Secondly, if you are taking out credit on a vehicle the lending company will tell you how many months the loan goes out until it will be fully paid up. Looking back at my previous example the loan would be fully paid up in 60 months. So you would pay a payment every month to the lending company for 60 months to fully pay it off. Now, you can pay it off early by paying more which would decrease the amount of months to pay it off.
Is credit good or bad?
Credit is actually a little controversial but I will explain to you both sides of this argument. Some people say that credit is bad because you cant afford a product if you cant pay for it that day. Another argument they have is that the bank takes an interest percentage which means you end up paying more for the product than the asking price. The arguments for credit being bad is very reasonable and there are many happy people that will never use credit to purchase anything.
On the flip side of the coin there are the people that think credit is good. I will admit I am one that believes credit is good (if used properly). You are able to purchase better products without taking all of the cash you have out of your account. Also, if you understand the way billionaires reached there level then you would know that a large majority of them became so wealthy by using credit. They would purchase assets that cash flowed per month more than the credit payment. For example, if you bought a $100,000 house for a investment property and your monthly payment was $500. Then if your income from it was $1,000 you would have a positive cashflow of $500 per month. In essence you would have bought a property for that gives you $500 per month without taking any money out of your bank account.
How to use credit to help you and not hurt you
Credit can be very powerful but also very dangerous at the same time. There have been millions of people that have used credit to hurt themselves, I want you to avoid that.
- Only buy a product or service on credit if you can truly afford it – What I mean by that is if you make $5,000 per month and your monthly expenses are $1,000 you would still have an extra $4,000 a month. Now if you wanted to purchase a car and the payment was $100 a month then you would be able to afford that car. This would leave you with plenty of extra money every month that you can do as you wish with.
- Pay off credit cards every month – Credit cards are notorious for having high interest rates. You will be spending a lot of money on interest every month if you leave a significant bill on your credit card. If you pay that off every month you will never be charged interest on what you purchase and your credit score will start rising.
- Mainly use credit for purchasing assets – One thing I want to point out is that I used the word mainly. I do understand that chances are your going to have to use credit to purchase liabilities such as a car. But one way to keep yourself safe is to use your credit to buy assets that put more money in your pocket every month. Just like I mentioned with the investment property example.
Understanding credit makes a huge difference in a person that understand the way it works. This was just a basic lesson on credit. I encourage you to even check out some blogs that explain credit in more detailed. Lastly, if you want to find out more about how the economy works Ray Dalio explains it perfectly (https://www.youtube.com/watch?v=PHe0bXAIuk0)