Credit cards are a staple of modern life. Let’s take a close look at how they actually work.
Let’s say, for example, you use a credit card to buy groceries today. When you use your credit card at the supermarket, you’re promising to pay for the groceries over the days or weeks ahead. In other words, instead of paying cash at the register, you’re agreeing to pay for them some time in the future, when you pay the lender who issued your credit card.
In the meantime, the lender who issued the card will pay the supermarket for your groceries, and until you pay the lender, you’re borrowing the money for those groceries, with the promise to the lender that you’ll make good.
Your credit cards are provided to you with spending limits, of course. That’s how much a bank or other financial institution is willing to lend you, given your history of paying back debts.
And that lender will likely charge you interest each month you don’t fully pay them back. Both your spending limits and the interest rate the lender charges you will depend on your “creditworthiness” - how they judge the likelihood you’ll pay them back.
Technically, that’s the bottom line: your “credit” is the amount lenders are willing to lend you.
Beyond the supermarket, credit can take many forms, from credit cards to loans to financing arrangements. In each case, you use credit - your promise of future payments - to get something before you’ve fully paid for it.
Let’s look at a few different types of credit, from big to small.
Home loans are typically big, involving a large amount of money. They require a lot of credit - a lender has to be willing to lend you a lot.
When a lender offers you a home loan, a lot of considerations are involved, but in simple terms, they’ll decide how much to loan you, and like groceries at the supermarket, you’ll enjoy the home over the years that follow, while you fulfill your promise to pay back your lender.
Buying a home is often the largest purchase most people make, and a home loan, also called a mortgage, can shape your financial future, with the obligation of payments every month, the advantages of increasing equity and access to more credit, often with your home as collateral.
Student loans can also involve a lot of money. Tuition can be expensive, and many students and families look to credit to help cover the costs.
With student loans (also called “education loans”), you might encounter specific conditions - a special set of interest rates or subsidies that extend how much you can borrow - because of the unique value our society puts on education. These loans are often combined with grants (which are similar to gifts; they aren’t expected to be repaid, typically), and the term of an education loan (in other words, the amount of time you have to repay it) is often long.
Over half of all college students depend on an education loan, sometimes several of them, and the average amount of student loan debt is $37,584. About 14% of Americans are currently making monthly payments on student loans.
Personal loans come in many sizes, depending on your need, your credit history and the lender involved. You might use one to access a lump sum of cash larger than what your credit cards might allow.
They’re secured loans, which means they require collateral - something of value the bank can claim ownership of, in case you fail to fulfil your promise to repay. Like your home or your car or expensive luxury items.
As secured loans, they’re not as easy to get as a credit card. The application and review process takes more time, and because of collateral requirements, they aren’t issued as frequently as credit cards.
Like credit cards, personal loans are often offered with variable interest rates, which can shift over time. But your monthly payments are more predictable.
Financing comes in many shapes and sizes too. But let’s look at a common one: using your credit to finance a new phone.
It’s a common situation, often bundled with specific services. A mobile service provider might agree to provide access to their data and voice networks - and include a new phone in the deal. Your agreement would likely include a monthly rate for network access, plus a schedule of monthly payments to purchase your phone.
If you look closely, you’ll see financing a phone purchase costs more in total than paying for it up front, in one payment. That’s because you’re paying in instalments - paying a little of the total cost each month - and you’re paying interest on the balance not yet paid each month.
Like groceries from the supermarket, you’ll enjoy the phone while you fulfil your promise to pay in full, and you’ll pay interest over the months ahead until the full amount is paid off.
However, some financing doesn’t end with ownership, like a paid-off phone that gets to stay in your pocket. Car leases, for example, use credit to determine how much you can reliably pay over time in exchange for use and maintaining a car.
Apartment rental agreements rely on your credit too. A prospective landlord will look at your credit history and judge how likely you are to fulfil your promise of monthly rent payments.
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Penalties are a common practice with credit. When you miss a monthly payment or can’t pay the full amount, your lender might charge fees or increase your interest rate to dissuade you from doing it again.
Most lenders will report your missed or partial payments to credit reporting agencies, where other lenders can see it when assessing your credit in the future. That’s a harsh but common penalty, resulting in loan caps, spending limits and higher interest rates for years to come.
Credit gives us access to things and experiences we might not otherwise enjoy, because we often don’t have the funds to pay the full price up front. Credit can also fuel learning that enriches your entire lifetime. And it can enrich friends and family, when we share the advantages and rewards.
If you don’t have it yet, download the Bright app, connect your accounts, and with your personalized Bright Plan, start enjoying on-time payments automatically. It’s one of the best ways to boost your credit score, and your Bright Plan finds ways to save you money too.
To really focus on raising your credit score, add the Bright Credit Builder - every payment counts toward raising your score. And check out Bright’s other services and features, from targeted saving to streamlined credit management - all ways to make the most of your credit and keep you on track to financial well-being.
After graduating from Princeton, Petko built his career in financial services Petko is a serial entrepreneur and an expert in Banking and Financial services