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FKD 101: What Is Credit?

Buying the entire bar a round of shots will make you look really cool. But not paying the charge back on time? Not so much.

With that being said, repeat after me: “Credit cards are not free money.”

While that American Express can feel like the plastic key to adulthood, it’s incredibly important to understand the concept of credit before signing up for a card. Student loans are hard enough to pay back without a mountain of credit card debt on top of it.

Your street cred(it)

Credit is your street cred as a borrower. It lets banks/credit card companies/future employers know how likely you are to repay your debts, and do so on time. If you have “good street cred,” aka a good credit score, you will usually be offered a lower interest rate because you’re likely to pay your bills on time. Awesome!

How does it work?

You can think of each swipe as a small loan being taken out to pay for the purchase. The point being that you will swipe now and pay later. At the end of the month you’ll get a bill for all of the charges you’ve racked up. If you can’t pay the entire amount, you’ll be charged an additional fee, called interest.

Interest

By charging a percentage of the purchase price, interest is how lenders (from car dealers to credit card companies) make money. Interest rates depend on the plan or card you have and your credit score (more on that later). While “swipe now, pay later” is a catchy way to think of credit, you should actually try and pay off your bill as soon as possible. By only making minimum payments each month you end up paying much more money than the initial cost of the charge. “The longer you pay, the more you pay.”

Here are two charts from Better Money Habits to help visualize things:

princple payment

 

 

purchase chart

 

Credit report/score

You can think of your credit report as your borrowing history’s report card with a dash of personal info. It details how much you’ve borrowed, how you paid it back and how long it took you to do so. It also has your current and past addresses, social security number, employment history, account information and all inquiries made about your credit history.

You can think of your credit score as the Sparknotes version of your credit report. Most people just look at the score as a quick summary of the whole report for the same reason you didn’t really read all of Crime and Punishment in 10th grade lit class…cause ain’t nobody got time for that. (Mr. Schott, if you’re reading this, I promise I read the whole book.) The score is a number ranging upwards of 300, which is calculated by a computer that looks for patterns, characteristics and red flags in your history. The higher your credit score, the better your credit is.

300-629: bad credit

630-689: average credit

690-719: good credit

720 and up: excellent credit

So … Credit or Debit?

Avoid large, unplanned splurges on your credit card and backloaded payment plans that only cost a little now, but a whole lot later. In short, if you didn’t budget it, you definitely shouldn’t swipe it. Plastic may be flashy and exciting, but cash is still king. Unless you want to live off Ramen Noodles forever, make sure that you have enough money in your bank account before you buy those new Beats that you TOTALLY (do not) NEED RIGHT NOW. A good rule of thumb is to never surf Amazon late at night with your credit card within reaching distance.

Using credit doesn’t always have to be a bad thing, though. You can start building a good line of credit by charging regular monthly expenses, like rent or gas. Since these expenses are generally the same from month-to-month, there shouldn’t be any surprises when your bill comes in the mail. That also means you should be able to pay off your bill without any interest charges and be able to start building good credit.

 

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Header image: Shutterstock

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