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What is Credit

By Edited Jan 27, 2014 0 0

A Beginner's Guide to Credit

Credit. Few words are used as often in our modern language. In fact few words even seem to be more important in our modern language. Obliviously the word money outranks it but a quick Google search brings up about twice as many results for the word credit as it does for the word love. If a Google search is indicative of anything, and most certainly it is, then we are twice as  concerned about financial credit than we are about love. That’s probably not a fair conclusion but what may be a more accurate conclusion is that we are more confused about credit than we are about love.

what is credit
Financial education seems to be sorely lacking in the United States especially. Many people have already started using that Discover credit card or Juniper credit card and don't understand what is taking place on their record.  Many young people are taught little to nothing in the home or school about how money works, how banks operate and the terms for lending and borrowing money. Many young people leave the home and go out into the world completely ignorant about such financial matters, until that is, they need to get a loan and can't, because they don't have sufficient credit; and worse, they don't know what credit is or how it works. Many wonder how you even check your credit score. Some start with "my free credit report" but just going on some sight and clicking "check credit report" isn't the best place to begin to understand the concept and usage of credit. 

Understanding Credit on a Small Scale

Credit is a financial term for trust. It's the trust that a lender has that a borrower will pay back the money borrowed and do so according to a set agreement. To make what may seem complicated more simple, think of it terms of an individual and a community of potential lenders, let’s say an extended family. Imagine a man named Joe. Joe needs to borrow $100 and so he goes to an uncle for a loan. Will Joe’s uncle lend him the $100? There can be a lot of twists and turns and other motivating factors in family relationships but for the most part the answer’s going to come down to how much Joe’s uncle trusts Joe.

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What will determine his uncle’s trust? Mostly, Joe’s history and reputation with borrowing money. Has Joe asked to borrow money before? Did he pay it back and do so without hassle or delay? Even if Joe’s uncle has never lent Joe money himself he may know of Joe’s reputation regarding money because relatives will talk about such things, especially if there’s ever been a problem with Joe and money. In other words, if Joe has ever borrowed money from his cousin and father-in-law and not paid it back, then Joe’s uncle will probably know about it. However, these aren’t the only issues on the table for Joe’s level of trust among his relatives. Is Joe currently working? Just what does Joe need the money for? Is it something necessary or something frivolous? Is the need a result of irresponsibility or bad luck? Does Joe like to gamble? Is Joe in any kind of trouble? Does Joe currently owe other people money? The questions can be many but they are all questions that will run across Joe’s uncle’s mind as he considered whether or not to lend Joe the $100. What it’s really all about here is Joe’s uncle making a decision as to the likelihood of getting his $100 back.

Understanding Credit on a Large Scale

Now, take the situation with Joe trying to borrow money from a relative and apply it to a much larger lending environment and this is what financial credit among banks is all about. Imagine Joe now trying to borrow $25,000 from a bank to buy a car. The people who issue the loans in the banks don't know Joe like his relatives so how will they know if they can trust him or not? This is what Joe's credit, and credit record is all about. All of Joe’s borrowing and payment history is reported by lenders and recorded on credit reports issued by various agencies. This is how the banks talk among each other like Joe's relatives to evaluate the level of risk involved in lending money to Joe. Any time Joe asks to borrow money the potential lender will consult Joe’s credit report and evaluate what kind of risk Joe represents. All money Joe has borrowed, has paid back, or has not paid back will be indicated on his credit report. Furthermore, all of Joe’s requests for loans will be on his credit report.  Joe’s credit report will also assign him a numbered score as an overall indicator of his creditworthiness.

Different Possible Answers

In all of these records and decisions about credit and loans the outcome for a loan request is often not simply a matter of yes or no; it's also a matter how much, and at what interest rate. It may be that the bank won't approve a loan to Joe for $25,000 to buy a car, but instead only $15,000.

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In each and every case, the more money Joe wants to borrow, the higher and more complex the standards will be for borrowing they money. Obtaining a mortgage to buy a house for example, which may involve hundreds of thousands of dollars is a much more involved process with much more stringent criteria. In the case of a larger loan such as this not only will the bank look at Joe's credit record but they will also have many of their own questions. They'll want to know about Joe's employment history. They’ll want to know his income. They'll want to look at several months' worth of Joe's banking statements. They’ll examine Joe’s situation for any signs of irregularities that may suggest problems or instability. Again, it’s all about the bank evaluating the risk Joe represents and how likely they are to get their money paid back. For this reason it's crucial that you know how to check your credit score.

Getting Started

If you’re a younger person just starting out in this world you won’t be able to borrow very much money. Just having a clean credit history isn’t enough, you need to have a credit history to begin with. To do this you need to start small and slowly build up, being responsible and cautious all along the way. The most obvious way to get started with this is to obtain 1 or 2 credit cards. This is where we go back to the Discovery credit card or the Juniper credit card. Use these cards sparingly, and carry only a small, if any, amount of debt on each card. Do this for a year and you will have the beginnings of a credit record that shows you to be one who handles credit responsibly. Be careful though. Credit cards can be quite tempting for making a lot of purchases. If you don’t keep on top of things you’ll build up a larger month to month debt and make it increasingly difficult to pay back. Even if you are confident that you can keep making payments on a credit card, a large amount owing on a card will count against your credit report. Yes, every little thing matters, and accumulates over time. By the way, there are many sources online, such as Equifax or Experian, or "my free credit report" where you can access your credit report, at least in some form. Stay on top of it, practice self-control and patience, and handle credit responsibility. Do this, and your credit report will become a great friend, always there for you whenever you truly need it, like an old favorite uncle.

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