Recently, my 15 year old sister asked me a simple yet complex question, “How does credit work? I have a debit card, I don’t need both do I?”. She had been recently getting mail from banks trying to entice her into their latest credit offering. To most the idea of a 15 year old getting a credit card sounds like a very bad idea, but I thought this would be actually a great opportunity to teach my sister some financial lessons. Lessons I had to learn the hard way…
Credit gets a bad wrap
After graduating from college I finally went and truly educated myself about the world of credit. After learning the fundamentals I was able to add nearly 100 points to my credit score in about a year. The more I learned about credit the more I realized most people had no idea how it really worked. Even my parents had serious misconceptions about how credit worked. Many people see credit as this thing to be feared and only used when absolutely needed. I would agree that credit is a bit like playing with fire. But like fire, understanding how to properly use credit can literally bring you out of the dark ages.
“…understanding how to properly use credit can literally bring you out of the dark ages”
Credit is basically a loan
Banks and other business entities will to loan you money to do whatever you please with it, and in return you agree to pay them back… with interest.
…credit is basically a loan that you pay back… with interest
Yup so when you get that shiny new plastic card essentially you are getting a loan from the bank that sent you the card. Okay well not exactly. To be more accurate the bank has agreed to loan you up to a certain maximum amount known as your credit limit.
This is what makes a credit card different than a debit card. While a debit card represents the money you have in the bank, a credit card represents the money the bank will loan you.
You can buy whatever you want with that card (as long as they take credit) until you have spent up to your credit limit (the total amount of money a bank is willing to loan you). Of course you never ever want to do this and I’ll explain why later.
Credit cards are for building trust!
The biggest mistake you can make when you get a credit card is to think that it is essentially free money, or extra money for you to use when you get low. Instead you should view your credit card as a tool for building trust with banks/lenders.
“…view your credit card as a tool for building trust with banks/lenders”
For you to understand how a credit card does this or why building trust with banks/lenders is important first we have to revisit topic I mentioned earlier interest.
The power of Interest
Ahh interest — this is probably the most important concept to understand when dealing with credit.
Interest is what creates wealth.
Interest is putting your money to work for you.
Interest is one of the most powerful forces in the known universe!
For example, say you have $1000 and you loan it to your friend. Your friend has agreed to pay you back tomorrow — with 10% interest. Tomorrow comes and your friend, being trustworthy, makes good on her promise and pays you back $1000 plus $100 in interest that you guys agreed upon.
10% of $1000 is $1000 x .10 which equals $100 !
Yes you’ve just made $100 with literally no work at all. All you had to do was trust your friend would pay you back.
Who can you trust?
Now you’ve entered into the knowledge of how what true wealth is.
Essentially those with money, loan it to people who they can trust, and in turn those people pay them back the money with interest.
Imagine if you had a million bucks and you could rely on that trustworthy friend to pay you back with 10% interest every time… you’d make $100,000 every time they paid you back… You could live on the interest you make alone without ever spending your original million.
What does this have to do with credit?
Well… everything really.
Banks want to loan people money so that they can collect interest payments…
So when you get a credit card, this is essentially the bank loaning you money. When you start out they’ll give you a few hundred dollars. But as you show you can pay your debts, proving your trustworthiness, they’ll be willing to lend you more.
Which I know probably has you wondering… what’s in it for me? Why do I want to help make bankers rich?
For an answer to this question — check out the next episode:
The TL;DR (Too Long; Didn’t Read)
- Credit is essentially a loan that you pay back — with interest
- While a debit card represents the money you have in the bank, a credit card represents the money a bank/lender will loan you.
- Credit Cards should be used to build trust. Lenders want to know they can trust you to pay back a loan.
- Banks make money by lending to people they can trust will pay them back with interest.
- Interest is literally what creates wealth
- As you use your credit card and pay your debts you will demonstrate your trustworthiness. In turn they will be willing to lend you more, at lower interest rates
- On the next episode: What is a credit score anyways?