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What is Credit?

You may have heard of a credit card or a credit score, but what does credit actually mean?

Essentially, credit is a form of borrowing. When you use credit, an institution or company agrees to lend you money, and you promise to pay it back after a specific amount of time.

How does credit work? Well, when most people make big purchases, like buying a house or car, they don't have enough cash on hand to purchase the item outright. Instead, they use credit to pay the full price of their item over time, a little bit at a time. This can be done through a loan. A bank or credit union will give you enough money to purchase the item, and you have to pay it back over a specific period of time. Student loans, mortgages, and credit cards are all forms of credit.

For example, let's say you buy a car for $10,000. You pay $2,000 upfront, and the bank agrees to give you a loan for the other $8,000. You and the bank agree that you will pay the loan back over 5 years. For simplicity's sake, let's ignore interest. This means you have to pay back at least $134 every month for 5 years. Using credit, you are able to split the burden of a large purchase over time.

Credit cards are another use of credit. When you use a credit card, you can buy items without actually paying for them upfront. You can buy items using the card, and at the end of every month, repay the creditor (the company that pays for the items upfront) for all the items you purchased. This changes things a bit, as instead of paying individually for each item, you end up paying one large sum at once. There is a lot more to the use of credit cards, which I'll discuss in an article coming soon.

What happens if you miss a payment? Well, your credit score, a number that reflects how well you pay back loans/debt, will go down. The goal is to have a high credit score, which you can achieve by making payments on time. When you start building credit, usually once you open your first credit card, your credit score is low. As you use your credit, making payments on the card, your score will increase over time. A higher credit score will help you get better loans, which become important once you start purchasing large items (homes or cars) or if you want to start a business.

It is important to remember that credit is a form of debt, and if it is not handled properly, it can be dangerous. However, credit can also be utilized to your advantage, by minimizing upfront costs so your money can be invested elsewhere. Credit is an essential part of life that is immensely helpful to many.

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