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  4. Credit Defined

Credit Defined

There are several items that you will need to understand when it comes to credit.

  • Credit: The ability to borrow money.
  • Loan: Money that is borrowed from a lender that must be paid back.
  • Interest: When you borrow money, you make a promise to pay back the money you borrowed plus extra. The extra amount is called interest. Interest is your cost to borrow the money.

If you are careful with how you use credit, it can be very useful. If you are not careful with the way you use credit, it will cost you more and can cause other problems.

The type of credit we’ll talk about in this section is personal or consumer credit. You have probably heard the term “good credit.” Having good credit means that you make your loan payments on time. If you have a good credit record, it will be easier to borrow money in the future. If you do not use credit responsibly, it will be harder and costlier to borrow money in the future. It may also make it harder to find a new job or rent an apartment.

Why is Credit Important?

Credit is important because it:

  • Can be useful in times of emergencies.
  • Is more convenient than carrying large amounts of cash.
  • Allows you to make a large purchase, such as a car or house, and pay for it over time.
  • Can affect your ability to obtain employment, housing, and insurance depending on how you manage it.

Collateral and Guarantees

When a financial institution agrees to lend you money, they will want some assurance that you will pay them back. Sometimes your credit is enough, but often they will want the loan to be secured by collateral or a guarantee.

Collateral

Something you provide the lender to secure a loan. Example: You pledge an asset you own, such as your car, to the lender to secure the loan. If you do not repay the loan, the lender can take the asset and sell it to help repay your loan.

Guarantee

A form of collateral. Example: Cosigning is a form of guaranteeing a loan. If a person with no credit history asks another person to cosign a loan, the cosigner is equally responsible and has to pay the unpaid loan balance plus interest if the borrower defaults.