Credit is the tool that allows you to purchase things without paying for them up front. Though fiscal responsibility and managing your debt is highly important it is often infeasible to buy high dollar items and services such as a car, house, or schooling without having the ability to pay for it over time. But your ability to secure these credit lines depends on your credit worthiness.
If you had a friend that asked to borrow $20 with the promise that they would pay you back next week, you might loan it to them knowing they were good for it. You trust their credit worthiness. But if next week came and they not only did not pay you back but instead asked for another $20 it wouldn’t take long before their credit worthiness would become devalued in your eyes. Maybe you continue to loan them money but only on the condition that they do you some additional favors or pay back a little more than they borrowed. This additional payment offsets your risk in the same way a bank charges you a higher interest rate due to your credit score or other criteria. If your friend STILL couldn’t pay you back or only made small insignificant payments there would come a point where you would simply refuse to lend them any more money.
Now imagine that these totals weren’t in the hundreds of dollars but in tens of thousands of dollars or more. The risk of loss is far greater and banks take this risk seriously (or at least the good banks do). Having verified income or some other type of collateral to borrow against is important, but your credit report and credit score is a recorded log of your ability to use credit responsibly but also the ability to pay that money back. Lending standards have increased in light of our current economic conditions due to the number of people over the years that were given money with poor credit worthiness.
Assuming banks weren't bailed out by Government, free market principals would cause risky banks to go under and well run banks to grow and succeed. It is this threat of bankruptcy that keeps most businesses honest and healthy. If they know they are "too big to fail" a moral hazard is created. That threat of bankruptcy is eliminated and banks can make more risky loans because they know that they are either selling off that risk to others or the American taxpayer will take on that risk should they fail.
This situation can start to undermine the credit scoring system and has a trickle-down effect that can promote irresponsible use of credit. If you have a FICO score of 720 with good income, often times you've worked hard and were very responsible with your money to get it there. You've made your payments on time and for the most part you have lived within your means. But if someone with a score of 600 or under is also getting the same loan that you are the incentive to use credit wisely begins to deteriorate.
It is a serious problem but even if everyone gets away with it by having the American taxpayer bail them out (businesses and people) it will always be important to have good credit. The bailouts can only last so long. This is because the money the Government gets to bail out industries and individuals comes from either borrowing it from foreign investors like China and Japan through the selling of our U.S. Treasuries, taxing ALL Americans more (not just the rich), or having the FED print money out of thin air thereby devaluing our currency and making every dollar we have worth less. All of these methods are in jeopardy but that is a topic for another article.
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The worse type of credit you can use in terms of building wealth is revolving credit usually in the form of credit cards for the purpose of purchasing items of little sustained value. If you purchase a new pair of sunglasses or new designer shoes, most people are really purchasing something that they can’t afford to pay for immediately. The exception is when you use your credit to purchase the item to take advantage of credit card rewards and you pay off the entire balance when the bill comes in.
Most people get into trouble because they live beyond their means. They can’t afford luxuries and don’t want to save up for them. Credit cards allow them to purchase these items immediately. Even if your pay off these debts over time, you end up paying orders of magnitude MORE money than the original cost and value of those items. Most people don’t realize that buying a $200 purse today that you make minimum payments on with a 20% interest rate will take you 25 months to pay off and will cost you $245 when it is done.
That extra $45 may not seem like a lot to you until your look at a credit debt of $15,000 with a minimum 3% payment. It would take 50 years to pay it off and would cost a total of $33,744.12. Of course you won’t wait 50 years to pay something off, but also consider that whatever you bought will break down or be out of style and you’ll need a new one. It is very possible, and in fact likely, that you will be paying interest on the next item before even paying off the first one.
Usually when it comes to these types of retail items the more debt your pile on the more wealth you are giving away to the credit card companies. It isn’t just the $18,744.12 that you paid in interest on a $15,000 debt, but the potential money you could have earned on that money! This is called Opportunity Cost. That same $18,744 that you paid in interest could yield $25,292 after 10 years with only a conservative 3% interest rate. If you also take into account the original $15,000 if you didn't spend it in the first place, you would have about $45,500 after 10 years. That would mean you could nearly triple your money in 10 years. Compounded interest is VERY POWERFUL and it would work in your favor or work against you as you can see.
The amount of money you pay in Interest could amount to hundreds of thousands or even millions of dollars over your lifetime. This is money you could use in retirement or something you could pass on to your children to build multi-generational wealth.
This doesn’t mean you can never buy any luxuries or increase your standard of living. But funding these luxuries through credit WILL destroy wealth in virtually every scenario. Not everyone has cash to pay for a house, car, or college but you should try to pay down your debt as quick as possible so you can start to use the Interest in your favor to build wealth.