Credit cards. Credit scores. Credit debt. It all revolves around “credit” but, what is credit and why is it so important?
Let’s begin with the basics, the term “credit” refers to a person’s ability and history of obtaining goods or services and paying it back later. It’s different from debit or cash because credit means that something will be paid for after a purchase is made, whereas debit or cash means that the money leaves your pocket or bank account as soon as you purchase something. So, when you use a credit card, you’re saying that you will pay for it later. If you use a debit card, a gift card, or cash, you are paying for it right then and there. With a credit card, you can build a reputation — aka a credit score — that reflects your history of being able to pay for that purchase later.
Why does this matter?
For a lot of big purchases, people want to know if they can trust you to pay it back. For example, when you want to take out a loan, lenders are going to look at your credit score/credit history (your history/reputation for being able to pay off purchases) and they will make their decisions based on that. So, if you have a bad credit score because you don’t always pay off your purchases or you have accumulated credit debt, then lenders may not loan to you because they don’t think you will pay it back.
How do you accumulate credit debt?
This tends to happen when people open credit cards, purchase things that maybe they can’t afford at the moment, but they think they will in the future, but they don’t or can’t pay it all off in time. This is such an easy mistake to make, but it really hurts your credit score, and you can accumulate credit debt, and both of those things are bad.
For most credit cards, you have a statement and a deadline every month. The credit card company will send you a statement each month that tells you how much you have to pay before the deadline/when the amount is due. If you don’t, then you start accumulating credit debt. There is usually a grace period (minimum of 21 days) after you receive your statement and before your payment is due.
Let’s use an example to understand this better. I went to the grocery store at the beginning of the month and spent $100 on groceries, then I went to get my haircut a week later and spent $50. I put all of these purchases on my credit card, so none of that money left my pocket or bank account at the time of the purchase. But then, I get a statement from my credit card company that says I need to pay the $150 before the first of the next month.
From here, it can go down a lot of different paths. Ideally, I would pay the $150 from my checking account before the deadline, this is how you build a good credit score and good credit history. But if I only pay a part of the full amount by the deadline, then it starts getting tricky. Let’s say that I only paid $75 of the $150 that I owe. Suddenly, the $75 that I didn’t pay on time becomes $100 with late fees and interest that the credit card company charges me. This can continue increasing with each month that I don’t pay it off in full.
So, not only do my purchases become much more expensive than I had originally planned for, but my credit score goes down, and my credit history shows a “delinquency”. Down the road, lenders may not trust me and will refuse to give me a loan.
How can I avoid this?
Looking back, I should have paid the $150 in full before the deadline. That is the easiest way to avoid fees, interest rates, bad credit history, and low credit scores. If possible, I can set up automatic payments so even if I forget to pay it off, the credit card company can take it right out of my checking account when it’s due. But I also need to be careful that I don’t spend more than I can pay off – a good rule of thumb is to never buy something with a credit card that you couldn’t pay for with your debit card or cash.
Credit is tricky, this is just a quick introduction to understanding credit and how it works. Join us as we explore credit and debt through a series of blogs during the month of August. In the following blog postings, we will explain more about credit scores, debt, and how to build a better credit score and credit history.
Of course, you can always reach out to Mary Rigg Neighborhood Center for more help; connect with someone on our Family and Financial Resource team by calling 317-639-6106.