In previous articles, I’ve discussed what credit is, and how you can start building it as a teenager. Now, you might be thinking, “Okay, I understand credit, but what can I actually do with it?”. Well, once you have a developed credit history, you can start utilizing it in a few different ways. In this article, I’ll be talking about a few different forms of credit and their various elements.
The first and most popular form of credit is the credit card. I’ve discussed credit cards a little bit previously because they’re the most straightforward way of building credit early. To summarize, credit cards are essentially short-term loans. You can make purchases using a credit card instead of cash. With credit cards, you don't actually have to have money in your account when you make the purchase, but you do have to pay off all purchases you made every month. Credit cards are usually used for smaller, everyday purchases, like groceries. There a ton of different forms of credit cards, ranging from secured credit cards to charge cards. In the near future, I’ll dedicate an entire article to the different kinds of credit cards.
Loans are another popular form of credit. These can range from 5-year auto loans to 30-year mortgages, or home loans. Loans are used to make purchases that are much larger than normal. For example, the average person isn’t able to go and purchase a house outright, so they’ll take out a home loan to spread the cost over time. A similar concept applies to auto loans, used to buy cars. This sums up the goal of a loan; paying for an item over a long period of time.
Why is this? Well, without a loan, if you’re looking to buy a $10,000 car, you would need to have $10,000 saved up, in cash. Once you purchase that car with cash, your $10,000 is gone completely.
With an auto loan, you are able to have a smaller amount of cash on hand, say, maybe $2,000. You use this money as a down payment to reduce the amount of the loan, so you would have to take out an $8,000 loan instead of the full $10,000. Now, you can break up your payments over, say, 5 years, and pay a couple hundred dollars every month for those 5 years.
However, taking out a loan comes with the additional cost of interest, a topic I explore in detail in this article. Interest is a small portion of the total loan that you would have to pay in addition to the loan amount. This is the cost of taking out a loan. In some instances, interest rates may be so high, taking out a loan doesn’t make any sense. In other cases, interest rates may be so low, that the loans are seemingly profitable.
How is this possible? Well, it revolves around the concept of opportunity cost and the time value of money. Interest rates that are low enough can be appealing because you can put your cash into other forms of revenue-generating investments, like stocks or a business. This way, you can generate more money with the cash that you have by taking out a loan than you would have saved by not taking out a loan. This can be confusing, so if you're interested in a more detailed explanation, read more about this concept here.
In addition to home and auto loans, student loans are another common use of credit. These loans are used to pay for education costs, covering tuition, books, and living expenses as a student. There are a couple different types of student loans. The first kind is loans offered by the federal government. These tend to have lower interest rates, and you don’t need to have any credit to take these loans out. However, to get student loans from a private institution, like a bank, you will need to have an established credit history or have a cosigner, like a parent. Private student loans also tend to have higher, variable interest rates.
Because this is a topic that's important to my audience, I’ll dedicate a few, in-depth articles to it.
Another, slightly more obscure, and certainly more risky, form of credit is called margin. This is a form of credit offered by many brokerages, or platforms that you can use to buy and sell different assets (stocks, bonds, etc). With margin, the broker will loan you money to buy different stocks or bonds. However, this is an extremely risky method of investing and is inadvisable for most people.
If you’ve read my other articles on credit, you’d think I’m beginning to sound like a broken record, but it's important to reiterate that credit must be handled properly. It is not free money, and if you treat it like it is, your credit report and score will be severely damaged. Remember to only use what you can afford to pay off, and make sure to make all payments on time, in full.
In short, credit can be utilized in many different ways, from paying for college to purchasing a home, credit can help you do it all.