What is credit? How does it impact you?
Credit cards are a staple in this world, and for many of us, we understand that, but do we really know what credit is and precisely how it works? Nowadays, you can throw a rock and hit someone carrying a credit card in their wallet. Most likely, you have multiple credit cards with different banks that offer various rewards every time you make a purchase.
Today, I want to give you a little back story into the history of credit and how it became so popular in the U.S. Also, I will be discussing how it works and why it is so important. Suppose you are ever in a conversation about credit or see something about credit on social media. If that is the case, at least you will understand the basics!
History
The method of using credit to make purchases was first recorded over 5000 years ago by the Ancient Romans. Records documented how some citizens would receive credit, such as silver coins from a wealthy family or establishment. As well as receiving a loan for farming equipment or purchasing a new home.
The mantra for credit or credit cards is that you are buying something today with the intent to pack back the amount in full at a later date. Much trust is given to the credit user as they are responsible for paying the debt back. In Latin, the root word of credit means belief or trust.
For Americans, the first time many of us ever heard of credit being used as a form of payment was during the 1800s. Generally, you would see some Americans purchasing a home with credit provided by the home lenders.
As we progressed, the 1900s was when the concept of credit started to become more popular for everyday usage. Americans would use credit for buying groceries, farm equipment & material, and furniture. The idea would be that they would pay the lender back on a week to week or month to month basis until it was repaid.
One of the biggest game-changers for credit usage was Henry Ford’s 1908 Ford Model T., which became available to the public. It cost around $850, which is the equivalent of having $20,000 today. As you can imagine, most people did not have that kind of money lying around. Let alone the FULL amount to pay off the car entirely.
The strategy Henry Ford signed off on to provide a credit line for customers was the layaway method. This meant that you would have an agreed-upon weekly amount you were supposed to pay, and once you paid off the car’s price, you finally got to take the car off the lot. That concept is so foreign to people today and would result in a massive tank in car sales. General Motors foresaw that happening in the future, so they created the “car loan model,” allowing clients to purchase the car now and pay it back later with credit.
Following car loans, Americans saw the first credit card created in the 1950s called the Diners Club credit card. The card allowed people to purchase items that fell into the traveling and entertainment categories. However, the most essential trait about this credit card is that it was called a charge card. A charge card is a credit card that must have any balance or money owed on the card paid back before the next month. Charge cards must always be paid off entirely before the next month.
A revolving credit card allows you to carry the debt balance over into the next month. Around 1958, revolving credit cards became popular. They would soon be the standard because they will enable the bank or lender to charge you interest on any debt you carry over into the next month. The interest charges alone are standard ways a bank pays itself (while pushing you further into credit card debt).
So how does a credit card work?
As most of us already understand, when you are ready to make a purchase, you will swipe your card, use a chip reader or use the tap function. During that time, your credit card lender and the establishment you are making a purchase from will ping encrypted messages back and forth to one another. Keep in mind that all of this happens in less than a second.
The establishment you are purchasing from is asking your credit card lender if you have enough credit on your card to make this purchase. When the purchase goes through, you have enough to satisfy both parties.
During the 60s, credit bureaus became more popular. Their mission was to make information about your credit and the credit rankings public every month. Over time, we saw three credit companies become popular: Transunion, Equifax, and Experian. These three companies are usually the go-to for keeping track of individual credit reports.
How then are you able to accumulate a credit score or credit history? Typically, you will need to take out a bank loan or have a credit card associated with your name. The point of credit history is that it informs all lenders about your spending habits and your ability to pay back on debts you owe. Credit history affects your credit score (it ranges from 300 to 850).
A credit score is important because this number is what lenders use when determining whether to give you a loan or not. In the past, people would receive a loan based on word of mouth and how trustworthy they were to thy neighbors. Today, lenders are looking at the paper trail of how reliable you are based on past financial behaviors.
Impact on You!
A credit score will impact if you want to receive mortgage loans, car loans, and student loans. Also, things like renting apartments, being hired for a job, or receiving a credit card with a low APR (annual percentage rate) can depend on your credit score.
A company you are probably familiar with is FICO, known initially as Fair Issac Company. The goal of this company is to allow both you and lenders to see your credit score. Generally, a credit score of 650+ is considered a “good” score by most companies and lenders. Scores that are 700+ provide you with more financial advantages.
Good credit allows you to receive better deals with credit card companies for higher loan offers. As well as, renters & buyers are more inclined to enter into an agreement with you. Most credit card companies educate their clients to keep their credit card usage below 30% on their cards every month. For example, if you have a credit card with $1000 as the maximum credit amount, you don’t want to have a balance that you owe more than $300 by the end of the month.
Today, credit is considered an essential financial function that influences many decisions we make throughout life. Most people cannot easily make large purchases in full by only using cash. Large purchases like buying a home, a car, or paying off all of your student loans can be near impossible to pay for with money in one transaction.
Most people want these things now and are willing to pay for them down the line, hence credit cards and having access to credit! If you took just 5 minutes to think about all the things you purchase or use a credit card on, I’m sure you’ll be shocked to realize how reliant many of us are on credit companies.
This concludes today’s article, and I hope that it was helpful to you and got you thinking about understanding financial literacy. I always want to hear your thoughts and questions, especially about finances. Please email me your questions and leave comments below because I want to know what you think. Check out the website to keep reading more!
And remember, like Earl Nightingale said, “Everything begins with an idea.” See you again next time!