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(From the Financial Literacy Blog) – Within the U.S. financial system, credit is the ability to borrow money to access goods or services with the understanding that you’ll pay later. Credit unions, banks, and other lenders issue credit to people who want to obtain something now, but either can’t or don’t want to pay for it now. Before you are granted any credit, lenders determine your creditworthiness, or how likely you are to pay the money back in full and on time.
To determine your creditworthiness or how likely you are to make your payments, your financial institution will usually request your credit report from the three main credit bureaus: Experian, TransUnion, and Equifax. Throughout the year, credit unions, banks, credit card issuers, and other lenders report your payment history to the bureaus. On-time payments, late payments, purchases, credit limits, and balances owed are all reported. The credit bureaus compile that information to create a credit report that assesses the likelihood that you will repaying the debt. The information on your credit report will help lenders decide whether or not you will be granted a loan, and if so, what your interest rate will be.
An interest rate is the amount a lender charges for the use of funds expressed as a percentage of the original loan. If you have a good credit history, you will likely get lower and more favorable interest rates on your loans or credit card—meaning you’ll pay less over time than if you had a poor credit history.
A credit card is an example of revolving credit. With a credit card, you are given a maximum borrowing limit, but you don’t have to pay the bill in full each month. However, you do need to make the established minimum payment. If you decide to make a partial payment instead of paying the balance off in full, the remaining balance will carry over to the next month. If you carry over funds, you can be charged interest. If you pay off your balance in full each month, you can avoid paying any interest at all.
For example, let’s say you bought a $1,000 refrigerator with your credit card. For this scenario, we’ll say the interest rate on your credit card is 18% and your minimum monthly payment is 3% of your balance. At 3%, your minimum payment each month would be $30. If you only paid the minimum each month, it would take you 93 months to pay off your credit card and you would have spent $698.38 in interest alone––for a total of $1,698.38. If you paid $200 a month instead of the minimum payment of $30, it would take you six months to pay off your credit card and you would have spent $47.53 in interest––for a total of $1,047.53. If you didn’t carry a balance and simply paid the $1,000 at the first payment due date, you wouldn’t be charged any interest at all.
Understanding credit is incredibly important, as it can help you finance major milestones in your life—whether it’s buying a home, a car, or funding your education. Credit reports are often pulled by lenders, landlords, and even employers—meaning credit influences all aspects of your life. If you want to know your creditworthiness and see where you stand, you can request your credit report at AnnualCreditReport.com. Federal law entitles you to one free credit report per year from each of the three main credit bureaus.