Understand Credit And Debt In One Breath

Wednesday, March 9, 2011, 2:00 AM | Leave Comment

Credit is the livelihood of my minuscule financial life. By definition, someone gives you credit, it becomes your debt. Mostly, credit may consist of interest, finance charges and fees, and of course the principal amount you are borrowing. So the money you borrow or rent becomes something in many folks lives a burden because of the extra “condiment” that goes on top of the principal.

However, you might be able to reduce the burden of debt by buying a home which can still potentially give you a good return on your investment (ROI). When you give the bank your money to put it in your savings account, it is obligated to give you some kind of interest at the end of a certain period.

It’s very easy to acquire debt. Borrowing or renting money puts you under the sharp knife of debt. How you handle the debt depends on why you borrowed the money in the first place. If you have borrowed it in the form of mortgage and handled it to the best of your ability – meaning you pay your monthly installment promptly, then over the years that you have stayed in your home, potentially the debt can get you a good ROI.

Traditionally, you would have accumulated equity that you may or may not use for meeting your other debt obligations you might have. There was a time when you stayed in your home for, let’s say, 20 years, and when you sold it, more often you would get the price better than your principal, interest payments plus any fees. In some neighborhoods, it probably still happens but the places have become quite rare these days.

You borrow money for something because you cannot pay for it out of your pocket. Maybe you could but you still borrowed because you wanted to use your cash for something else.

Enough about Debt. Who needs debt when you can get Credit

Some folks, like me, confuse the two words. Ultimately, the two become one. You accumulate debt because someone gives you credit. Your debt is a combination of raw credit plus the “condiment” mentioned above.

Credit card debt is something some folks can get rid of without getting into debt. Does that make sense? If you pay with your credit card, usually the creditor gives you a three week period to pay it off in full. If you do, you get credit but you shun debt. That could be the very basics of your financial life. Get credit, pay in full, shun debt.

The problem is your savings account at the most can give you as little as around 2%. More than that is quite rare. The interest you pay on borrowed money including debt from your credit card can run around 10% if not more. Less than that is quite rare. So you lose and you lose big if you borrow even though you are able to pay in cash.

There are basically five terms that you must understand about credit:

  1. Credit

    This is the trust that is bestowed on your shoulders. This is the amount that the lender is willing to give you and get you under the sharp knife of debt.

  2. Interest Rate

    This is the raw cost of capital. It is the rate that the lender charges you for the privilege of borrowing money. In other words, it’s the cost of the lender’s trust.

  3. Annual Percentage Rate (APR)

    This is the yearly cost including the raw interest rate, finance charges and other fees, all combined into one rate. All lenders and creditors are under obligation by the law to disclose APR to you before you borrow.

  4. Credit Rating

    Your credit worthiness is scaled and measured in terms of the risk the lender takes. It’s the prediction of likelihood that the borrower will pay the loan. It’s also a part of the lender’s risk management that includes how best you will be able to pay the loan back.

  5. Credit Score

    This is the mathematical calculation of a person’s credit worthiness. It’s kept by the credit reporting bureaus that release to lenders and creditors. The credit score can be between 300 and 850. The higher the score, the better your chances to get the total amount you have applied for and better (lower) interest rate.

In a Nutshell
It’s obviously better to understand credit and debt and what’s involved. If you don’t, just keep one thing in mind. Always spend less than you make.

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