Credit & Debt in Personal Finance

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  • 0:00 The Truth About Credit
  • 1:54 Pros & Cons of Credit
  • 3:14 The Truth About Debt
  • 5:10 Lesson Summary
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Lesson Transcript
Instructor: Toni Bonton

Toni has taught personal finance and has an MBA.

Credit and debt are the foundation of any form of finance. This lesson highlights the pros and cons of credit and debt as they pertain to personal finance.

The Truth About Credit

Tammy is in her first semester of college. One day while walking through the campus cafeteria, she passes by a table where a bank representative is signing students up for credit cards. Tammy has always been interested in getting a credit card, but horror stories about the troubles of credit and debt caused her to steer clear of them. Knowing she could not avoid the subject forever, Tammy decides to do some research to help her better understand the truth about credit and debt.

In its simplest form, credit is money that is borrowed to make purchases, when the borrower does not have the financial means to do so. The money is given in exchange for an agreement to pay back the amount over time, usually with interest. There are two main types of credit Tammy may encounter as she navigates credit.

A loan, such as an auto loan, is used specifically for the purchase of something approved by the lender. Someone who wants to buy something large, say a car, but cannot pay the full price up front, can go to a dealership or bank and apply for a loan. This loan will enable the person to make the purchase, up to a certain amount agreed upon by the lender and borrower. Once the loan is used for the purchase, the buyer will make monthly payments until the balance is completely paid off, but additional money cannot be borrowed. This is called installment credit.

On the other hand, credit cards can be used for anything as long as the amount the person wants to spend falls within the assigned limit. Let's say Tammy is approved for a credit card. The financial institution issuing the credit card will assign a set amount for Tammy to spend, based on what they think she can afford to pay back. If Tammy has a credit card with a $500 credit limit, she can spend up to that amount on any purchase. She can continue to use her credit card as long as she continues to make payments and has an available credit limit to use. This is called revolving credit.

Pros & Cons of Credit

Credit can be quite advantageous. Since credit serves as a source of backup funding, it can be used as a financial safety net when Tammy does not have the cash to make necessary purchases or as a tool to be able to afford large purchases over time.

Credit also builds the reputation of the borrower. When financial institutions make decisions about extending credit to borrowers, they look at how the borrower has handled previous situations involving credit. If the borrower has made payments on time in the past, financial institutions usually feel more comfortable issuing credit in the future, which can make borrowing money or buying things like cars or houses much easier.

Credit can also be intimidating. When a financial institution agrees to issue credit to an individual, it does so at a cost, meaning that the borrower will have to pay back more than the actual amount borrowed. The cost of using credit is the interest rate. That means when Tammy uses her credit card to buy $50 worth of groceries, she will pay back the $50 used plus any interest charged for that month. If Tammy does not make her payments as agreed, she risks having to pay higher interest rates, ultimately costing her even more. Not paying as agreed can also be detrimental to Tammy's financial reputation, causing financial institutions to think twice before issuing Tammy credit in the future.

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