In today’s world, the word “credit” seems to frequently come up in conversation. What is “credit?” Credit is defined as goods, services, or money being received in exchange of the promise to pay back a definite sum of money in the future. You can think of it as an I.O.U with very strict rules.
In 2008 at the age of 18, I got my first credit card (This was prior to the 2009 CARD Act which now requires you to be 21 to get approved for credit. Want to know what rules went in to affect in February of 2010, click here. In August of 2010, another set of rules when in to affect. For more information on those, click here.). Back then, there were things I didn’t know about credit, especially the types of credit that exist. I never really thought much about it till I got to college. One day during a random conversation amongst some friends, we inadvertently broached the subject of how we were all funding our college education. Some of us were on full-ride scholarships to our chosen institutions while others were on partials scholarships, and funding the rest of their education with student loans. This made me wonder what kind of impact student loans had on an individual’s credit.
During my research, I discovered there were two major types of credit, and they both impact your credit score (as one of the portions that go into calculating a credit score is the “types of accounts” in use/used). These two types of credit are as follows:
1. Open-End Credit (aka “Revolving Credit”)
This is a credit line that involves small repeated transactions. Revolving credit…!? You are probably wondering what that is; this is credit that doesn’t have a fixed number of payments. My credit card is a perfect example of open-end credit because I do not have a set number of payments that I have to make. I have access to the limit approved by my bank whenever I want, and in return all I have to do is at least pay the minimum on the outstanding balance when I use the card (just know that interest -- the price of borrowing-- can be very costly if you only decide to make only minimum payments). Store-specific credit cards, home equity lines… are also examples on open-end credit.
2. Closed-End Credit (aka “Installment Credit”)
This is line of credit on the other hand involves one transaction. It doesn’t only have a fixed number of payments/installment, but also a specified period that the payments must be made by. This is where student loans come in-- repayment of student loans happen post-graduation. The payments made are normally going to be fixed and maybe be for a 10-year period depending on the loan amount. Other examples of this type of credit include car loans, mortgages, personal loans, etc.
It is crucial to evaluate your finances and have an understanding of these two types of credit prior to borrowing/receiving credit. Some things that I took into account when I started using my credit card were as follows:
- Will I be able to afford borrowing such an amount based on my spending plan?
- How much credit can I use per my spending plan and do I have the ability to pay it back?
- Do I need to borrow less than the amount being offered to me to avoid the temptation of overspending?
Asking yourself questions like this will help you determine reasonable amounts to borrow. Therefore if the bank is giving you a $1000 credit limit and you know you can only afford $250, make sure your limit is reduced to that amount.
Some of you might be asking, -- well I am 18 and can’t establish credit due to the 2009 CARD ACT? What do I do? -- If you are not 21 yet, you can still establish credit by either:
- Signing up for a secured credit card(this requires you to put down a deposit that then becomes your limit)
- Having a co-signer
- Showing sufficient proof of income
- Getting small loan from an institution
Despite the word “credit” having a lengthy but befitting definition, in today’s world it is very beneficial to have an understanding of what it entails. As the wise Sir Francis Bacon once said -- “Knowledge is power” and being well-informed has a way of empowering the decisions that we make.