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Is Credit Good or Bad?
What is Credit?
When people hear the word credit, most people think of credit cards. Credit cards are only one product in a world of credit, however. Other credit products are:
- credit cards
- lines of credit
- auto/car loans
- student loans
- payday loans
- overdraft credit
And there are many other credit products. The main thing is that credit products give you money upfront (or on a revolving basis) for a specific purpose (or any purpose you choose) and make money because you pay interest on the amount you borrow.
Common Interest Rates and How to Calculate
Interest is what you pay for the privilege of borrowing money on credit and various products have different interest rates. Normally, interest rates are calculated on an APR basis (annual percentage rate). For example, a credit card usually has an APR of 20%. That means, if you use your credit card for $1,000; you are charged 1.666% each month (20% divided by 12 = 1.666%). That's $16.67 of interest per month, added to your credit card bill. Of course, you make your minimum payment, which usually includes all of the interest so you don't end up paying interest on the interest.
To calculate interest rates for yourself, first know this: 100% = 1, therefore 50% = 0.50, 25% = 0.25, 10% = 0.10, 9% = 0.09, 5% = 0.05, 2.5% = 0.025, 1% = 0.01 and 0,5% = 0.005.
Doing this conversion from percentage to decimal will help you to easily calculate the interest you will pay on money borrowed. Just multiply your total borrowed money by the decimal of your interest rate and that's how much interest you pay per year. Remember, interest in calculated per year or APR (annual percent rate).
So, if a payday loan company charges you $20 for borrowing $100... that sounds like 20% APR, right? WRONG! They require you to pay back within two weeks, so you need to multiply 20% by 26 = 520%. So, that is a credit loan with an APR 520%. If you borrowed $100 at this rate for a whole year, you'd end up paying back $520. That's crazy!
If you borrowed $100 on a credit card, you'd likely only end up paying $120 back at the end of one year.
Here are some examples with common interest rates:
20% - Credit Cards - $1,000 x 0.20 = $200 in interest for one year
7% - Line of Credit - $1,000 x 0.07 = $70 in interest for one year
4% - Home Mortgage - $100,000 x 0.04 = $4,000 in interest for one year
0.99% - Vehicle Financing Special Offer - $25,000 x 0.0099 = $247.50 in interest for one year
John Oliver Talks About Payday Loans
Good Use of Credit
Credit is a tool much like a knife - it can help you if you use it correctly, or it can hurt you if you don't use it properly. Thus, I always shake my head when people avoid credit altogether, because they've been unable to manage their credit well in the past. If you don't know how to use a knife, you shouldn't get rid of all your knives - you should learn how to use them properly. Credit is a tool and if you use this tool well, your life will be much easier.
Putting purchases on your card, knowing that you have the money to pay the entire balance off next month is a great idea; cards offer cashback, purchase protection, travel protection, etc. (read on to find out advantages of putting your purchases on credit cards). Using your credit cards on a regular basis also help build your credit profile, which will lead to banks lending you more money in the future.
Paying off your full balance each month is the best idea - this way, you don't incur any interest charges. But, even if you can't pay off the full balance each month, paying off the full balance every couple of months is better than nothing. You'll pay a bit of interest, yes, but at least you were able to get the things you needed by borrowing money.
Cash advances from your credit cards is not a bad idea, either, but only if it's for a good purpose. Let's say you just don't have the money to pay your rent this month, but you will have the money in a couple weeks... your landlord can't wait, so you take a cash advance of $1,000.00. You pay that back to your credit card in two weeks and incur interest charges of $8.75 at 21% interest APR. Big deal... you paid such a small amount for the convenience! If you had borrowed that money from a payday loans place, however, you would have paid an extra $200 after two weeks for borrowing that money. Now, not using a credit card is insane!
Why it is Better to Have Credit than Not to Have It
Let me give you a couple examples of why it's a good idea to have something as lowly as the credit card. Even though it's tempting to use your credit to buy frivolous things; if you can control yourself, credit cards are a very good tool.
1. When you buy things with credit cards, there is often theft/damage/fraud protection and an extended warranty. That's right, if you have the right credit card and you buy a TV with it and your TV gets stolen soon after purchase (for example, from the trunk of your car), the credit card will reimburse you. Or what if you bought a fake Rolex? Same thing, you can probably get refunded. And many credit cards will double the factory warranty up to an extra year!
You certainly don't get those benefits when you pay with cash or directly from debit. There was also the case in Europe where people pre-ordered iPhone 6s from a mobile carrier, but then the mobile carrier went bankrupt - sorry, but those who paid via debit were out of luck. Those who paid by credit, however, simply had visa/mastercard/amex/union pay recall those funds.
2. Credit and cash advances can help you out in a pinch. In one example, during an emergency for his dog, this guy was unable to come up with a $300 deposit for the emergency surgery his dog needed. Even if he had family/friends willing to lend him the money, it takes a lot longer to get those funds than to simply swipe your credit card. Furthermore, you definitely need a credit card if you're going to rent a car or a hotel, as those places require an authorization of funds (funds on hold while you use their services).
On a personal note, I was moving but didn't have any cash at the moment. Simple, I put my airplane ticket and moving costs on a credit card and all was taken care of. Simple. Also, many companies can take credit card over the phone and via email, but cannot take other forms of payment.
3. Travel medical protection, common carrier accident insurance and car rental loss damage insurance come with many travel credit cards. Many travel credit cards that require an annual fee offer free travel medical protection for you and your family when you travel. The beauty of it is twofold: if you travel a lot, the cost of travel medical protection more than covers the cost of the annual fee; and since the coverage is automatic on many cards (or on some cards, simply charge part of your trip to the card), it's one less thing to worry about. It also saves you about $25 a day when you're renting a car if it includes car rental loss damage insurance.
4. Credit cards offer points and cashback. So, even if you don't need those insurances, you can at least get a card with cashback. A typical card offers 1% cashback, so for every $100 you spend, you get $1 back in cash. That doesn't sound like a lot, but if you put all your purchases on your card, it certainly adds up over the course of months or years.
5. Credit cards help you build your credit. With proper usage of your credit card - that is, paying the monthly minimums on time, always - your credit profile will be built. You'll eventually be approved for revolving lines of credit, auto loans, mortgages, etc.
Bad Use of Credit
This section is going to be very short.
Bad use of credit is using credit for anything that is not an investment (something that you can make money off of).
Of course, using your credit for everyday purchases is fine, as long as you can pay it off in full when the bill comes at the end of the month.
How Businesses Use Credit
Now, let's look at how businesses and "rich people" make good use of credit. The average person probably doesn't know this, but businesses either thrive or die based on how much credit they have access to. I'll give you an easy example.
I used to work at a used car dealership where the owner had a $4.5 million line of credit. I don't know what the interest rate was, but let's just say it was 5% per annum. So, he'd use his line of credit to buy cars, and then of course would turn around and sell those cars at a profit. He had about 50 used cars on the lot at any one time, so you could imagine how much credit he was using. But of course, he was able to make more money by buying/selling cars than he was paying in interest, so he made a lot of money. If his return on buying/selling cars was 10% and he paid 5% in interest, well, he's making 5% on whatever money he was borrowing. Not a bad deal on such a large line of credit.
Another good example that we always see on TV is people who flip houses. Okay, so let's say someone had a $500,000 line of credit at 5%. So that's $2083 of interest per month, if the whole line of credit is utilized. The house flipper might buy a house for $400,000 and then invest $100,000 into fixing it up. He's really good, so he fixes it up in under a month and then sells it for $600,000. Wow, he just realized revenue of $600,000.
$600,000 revenue minus
$500,000 to pay back loan (money used for purchase and labor/materials) minus
$2083 in interest charges equals
$97,917 in profit. Not bad.