You have probably seen your parents paying the bills at one point in your life. You might have wondered, “Why are my parents paying for my Xbox controller now when they bought it for me a month ago? Wouldn’t the $1,000 they paid be automatically deducted from their card then?
The answer is credit– a form of payment that provides one with the ability to borrow any goods or services as long as they are intent on paying them back within a certain period.
For example, a new home buyer is interested in a $500,000 home but does not want to pay for it fully in cash. Then, they would apply for a 30-year mortgage—a form of credit. Assuming they put a down payment of 20% at $100,000, they are left with a $400,000 mortgage payment, which they are expected to pay back within 30 years. They may pay off their mortgage in monthly payments (most common), or they can choose to pay it off in full eventually.
There are three main types of credit: revolving credit, installment, and open credit.
Revolving credit is an open and ongoing line of credit. A revolving credit account consists of a credit limit–which is the maximum amount that can be spent. There are no fixed payments with a revolving credit account. In addition, one can choose to make only the minimum fees charged with revolving credit to remain in good standing with the creditor.
Credit Cards: A credit card is an example of a revolving credit account. There are no monthly fixed payments and one is expected to pay off the card balance by the due date, preferably earlier. One can also opt for paying only the minimum payment each month, but they would have to pay extra interest within the next payments to compensate. This can negatively impact one’s credit score as well, making it difficult to apply for loans in the future.
On the other hand, installment credit accounts are loans that must be paid back in increments throughout a certain time frame. The repayment structure consists of monthly fixed payments along with an interest rate. Some examples of installment credit include mortgages, student loans, and car loans.
Suppose a student chooses to take out a $50,000 loan for college for 10 years. Assuming a 4% interest rate, they will be making monthly payments of $526 until their debt is completely paid off.
Open credit is a form of credit that is due in full each period (typically each month). Open credit payments can include cell phone bills and utility bills (electricity, water, heat, etc).
For example, if an individual owes $100 in electricity bills for January, they would be expected to fully pay the amount by the end of the month.
You will probably gain exposure to revolving credit, installment, and open credit throughout your life which is why it is so important to learn about them from a young age! Learning about the different types of credit is an excellent way to financially prepare yourself for adulthood!
By Navya Nagelli