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What Is Credit?

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What Is Credit?

Credit is a loan of money, meaning you must pay it back after using it. It is not free. The loan may be for a short or long term. Sometimes the loan requires a formal application process. Other times, it is made by the use of a simple plastic credit card—once the borrower’s creditworthiness has been established.

Things To Know

  • When the creditor lends money, the creditor expects that the principal will be repaid in a timely manner with interest.
  • Credit lets you buy things you don’t have the cash for. But it is not free money.

Here is how it works

A creditor (a person or institution such as a bank or credit union) lends money for financial gain. When the creditor lends money to a debtor, the creditor expects that the principal (the original amount of money) will be repaid in a timely manner with interest. Interest is the amount of money the creditor earns for lending the money to the borrower. Interest is usually expressed as a percentage of the principal amount to be repaid in addition to the principal. Sometimes interest is called the finance charge.

Most credit transactions in the United States require you to pay monthly payments of both principal and interest. Examples of these transactions include monthly mortgage payments for homes, car loan payments, credit card payments, and medical bill payments.

There are limits

Credit agreements provide a credit limit up to which the borrower (you) can borrow. In some arrangements, the agreement ends when the loan is repaid. In others, the borrower can continue to borrow and repay amounts as long as the outstanding balance does not exceed the credit limit. These arrangements are called revolving credit. Credit card agreements are an example of revolving credit.

Why credit is so important

Without credit, the global economic system would grind to a stop.

Credit allows borrowers to immediately buy things they could not afford now. Most persons would not be able to purchase a house without credit. Most young adults do not have sufficient savings to afford the cost of even the most humble of homes. Yet, credit allows them to purchase a home that they can gradually pay off over time as their earnings increase. Without credit, many individuals would not be able to purchase an automobile. Credit also makes it convenient to make spontaneous purchases without the need to carry large sums of cash or checks.

Credit benefits both buyers and sellers

Credit benefits consumers by letting them buy things they need now even if they do not have the necessary money currently available, but will in the future. When used properly, credit is a great cash management tool. When abused, it can lead to financial disaster. The cost of credit can be greatly reduced by paying off balances promptly. The longer you take to pay off a credit balance, the more it costs you.

You can get insurance on your loans

Credit insurance protects you when you take out a loan in the event of your death, disability, or unemployment. It is available for nearly any kind of loan, including credit cards. You probably are not going to be eligible for credit insurance if you are over 65. It may vary by the state you live in.