Lesson 5: What Is Credit?
You’ve certainly heard the word “credit” before. Perhaps you’ve seen an ad that boasts “easy credit terms” or a sign that says “credit available.” But what does all this mean?
In this lesson you’ll learn the fundamentals of credit and what to look for when comparing loans. We’ll explain how credit can be an important financial tool and we’ll begin with a definition.
So credit, essentially, is just borrowing money to pay for stuff. It refers to all the different ways that someone can purchase something now and pay for it later. Whether you’re buying a car or a house, saving up that much cash might take forever. By borrowing the money for the purchase, you can use the car or live in the house and pay it off over a period of time.
All of this may sound great but there’s a catch. Using credit will almost always cost you more in the long run than paying for something upfront. The extra amount you pay is called “interest,” and one way to think about it is that when you borrow, you’re basically renting somebody else’s money.
If you decide to use credit, probably the most important thing to look at is something called the effective interest rate. Stated as an APR, or “annual percentage rate,” the effective interest rate allows you to do an apples-to-apples comparison of costs if everything else is equal. If the effective interest rate isn’t stated up front, you may need to read the fine print or calculate it yourself. Generally speaking, the lower the effective interest rate, the lower the cost of the credit.
There are tons of different types of credit, and chances are, you already use a few. There are credit cards, “rent-to-own” leases, personal loans, car loans, student loans, and mortgages. There are dangerous loans like title loans and payday loans. Loans can come from banks, credit unions, online lenders, auto finance companies, and retailers, just to name a few. With all of them, there might be fees and different payment terms, but the most important thing to watch for is probably interest.
So now you know the fundamentals of credit and what to look for when comparing lenders.