The Basics of Developing Credit

1. What Personal Credit Is

Think of personal credit like borrowing a friend’s jacket. You’re using something that isn’t yours with the promise to return it in good shape. Credit works in a similar way, except instead of a jacket, it’s money—and instead of a friend, it’s a bank or credit company. When you use credit, you’re borrowing money to buy things now and agreeing to pay it back later, often with an extra cost called interest. Let's see how interest works to your advantage and disadvantage with personal credit.

term to know

Personal Credit

The ability to borrow money for purchases or expenses with an agreement to repay it over time, often with interest.

1a. Forms of Personal Credit

Personal credit can come in a few forms, and many of these you are most likely familiar with:

• A credit card is a plastic or digital card that lets you borrow money from a bank or financial institution to make purchases. When you use a credit card, you’re borrowing funds with the promise to pay them back later. If you don’t pay the full balance by the due date, interest is added to what you owe.

did you know

Here’s an interesting fact: The total credit card debt in the United States was $1.08 trillion in 2023, and the average individual credit card debt totaled $6,000. Credit cards can be convenient for everyday purchases, emergencies, and building credit, but carrying a balance can lead to high-interest debt.

Here is a link to this information: www.cnbc.com/2023/11/09/average-credit-card-balances-top-6000-a-10-year-high.html

• A personal loan is a type of loan you can take from a bank, credit union, or online lender for personal expenses like home repairs, medical bills, or debt consolidation. You receive a lump sum of money and repay it over a set period, usually with fixed monthly payments and interest. Unlike a credit card, a personal loan gives you a fixed amount up front, and you pay it back in regular installments until it’s fully paid off.
• A car loan is a loan specifically for buying a car. You borrow the money from a bank or lender, get the car, and pay back the loan over time with monthly payments, including interest. However, if you don’t make your monthly car payments, the lender can take back your car.
• A mortgage is a loan used to buy a house. You borrow a large amount of money from a lender, buy the house, and repay the loan with monthly payments over many years, along with interest. However, if you don’t make your monthly mortgage payments, the lender can foreclose on your property and take your house back.
• A credit line is a flexible loan from a bank or lender that gives you access to a set amount of money that you can borrow as needed. Unlike a one-time loan, you can borrow, repay, and borrow again up to your limit. You only pay interest on the amount you use, not the full credit line, which is why a lot of people like credit lines. Typically, lines of credit are opened by homeowners who make home improvements, small business owners, and people needing a source for emergency funds.

big idea

Using credit can make life easier and help you manage large expenses without waiting years to save your money. But because it’s borrowed money, this also means keeping a commitment to repay it, which affects your finances over time. Later on in this lesson, we’ll dive into how personal credit affects your financial health. However, just know that credit is a convenient tool that, when used wisely, can make reaching your financial goals easier—yet, if used without caution, it can create a lot of financial stress.

Now that you understand what personal credit is and the different forms it can take, in the next topic, we'll look at the advantages of using it. Credit has some powerful benefits that can help you reach your financial goals and manage life’s expenses.

terms to know

Personal Loan

A fixed-amount loan for personal expenses, repaid with interest over a set period.

Car Loan

A loan specifically for buying a car, paid back monthly with interest.

Mortgage

A long-term loan to buy a house, repaid in installments with interest.

Credit Line

A flexible loan with a set borrowing limit; you can borrow, repay, and borrow again as needed, paying interest only on what you use.

2. Advantages of Using Personal Credit

Credit can be a powerful financial tool when used responsibly—meaning you don’t borrow more than you can afford to pay back. It offers benefits like convenience, rewards, and the ability to build a strong credit history that can open doors for future opportunities.

2a. Convenience and Flexibility

One of the biggest perks of using personal credit is the convenience it offers. Credit cards let you pay for items without carrying cash (which, let’s face it, most of us don’t have in our wallets anymore) and are accepted practically everywhere. Plus, having access to credit gives you flexibility—whether it’s to cover an unexpected car repair, snag that limited-time sale, or finally book that dream vacation.

However, if you’re planning to use your credit card abroad, there’s one extra step: You may need to set up your card for international use. A quick call to your card issuer or a quick request through your banking app lets them know you’re traveling, which prevents them from flagging your purchases as suspicious. Some cards also charge foreign transaction fees, so it’s a good idea to check that too.

EXAMPLE

Imagine you are on your way to work and notice that you have a flat tire. After a visit to the mechanic, you are told you need four new tires that cost $800. Instead of draining your savings, you could pay with a credit card and pay the total off over a few months, making the expense more manageable. However, if you don’t pay it off in full, you will owe interest, making the cost of the tires more expensive.

2b. Building Credit History and Credit Score

Using credit responsibly can improve your credit history and boost your credit score, both of which are important for future financial decisions. In an upcoming lesson, we’ll cover everything you need to know about credit scores in detail. For now, all you need to know is that credit scores range from 300 to 850. Having a good credit score (typically, from 670 to 850) shows lenders that you’re reliable, which can lead to better loan terms, lower interest rates, and easier approval when you need financing.

EXAMPLE

Paying off a credit card balance in full each month demonstrates that you can handle credit responsibly. Over time, this behavior builds a strong credit history and positively affects your credit score. Having a good credit score is helpful when you want to take out a loan or buy a house or a car because the better your credit score, the lower the amount of interest you need to pay on your loan.

So, what do credit card issuers get if you always pay your balance off in full each month? Good question, and the answer is that they still win. Here are the perks for credit card issuers:

• Transaction Fees: Every time you use your credit card, the merchant pays a fee (usually around 1%–3% of the transaction) to the card issuer. These fees add up significantly across millions of transactions and make up a substantial portion of card issuers’ incomes.
• Annual Fees and Other Charges: If your credit card has an annual fee, that provides revenue to the card issuer. They may also collect revenue from fees for foreign transactions, cash advances, and, sometimes, late fees if you miss a payment.
• Data Sales and Partnerships: Credit card companies gather data on spending patterns and may sell these data in an aggregated, anonymous form to third parties or use them to create targeted offers and partnerships.
• Incentives to Spend More: Rewards programs encourage cardholders to spend more on their cards to earn points, cashback, or miles. Even if you’re not paying interest, the extra spending increases the transaction volume and fees paid by merchants.

did you know

Landlords and employers also often check credit scores. Your credit score isn’t just for banks and lenders anymore—it can also impact where you live and even your job prospects!

• Landlords: Many landlords use credit scores to decide if a potential tenant is likely to pay rent on time. A good credit score (again, anything above 670) can help you get approved for an apartment, while a low score might make it harder or lead to higher security deposits.
• Employers: Some employers may look at your credit report as part of the hiring process. A strong credit history can reflect responsibility and reliability, while a poor report might raise concerns.

terms to know

Credit History

A record of how you’ve managed borrowed money, including loans and credit cards, showing lenders if you’re reliable with payments.

Credit Score

A three-digit number from 300 to 850 that shows how reliable you are at repaying debts. Higher scores mean you’re more likely to get loans and better interest rates.

2c. Rewards, Points, and Cashback

Many credit cards offer rewards like cashback, travel miles, or points that you can redeem for products or services like restaurants and shopping. Credit cards can provide added benefits at no extra cost if used wisely as a perk for being a card member. Essentially, you can earn money or points for spending money you would be spending anyway.

EXAMPLE

If your credit card offers 2% cashback on groceries, it means that you’ll earn 2 cents back for every dollar spent on grocery purchases. So, if you spend $100 a week on groceries, you’d earn $2 each week in cashback. Over a month, that’s about $8, and over a year, it adds up to around $100 in cash rewards just for buying your usual groceries!

2d. Access to Large Purchases

Credit allows you to make large purchases, such as a laptop for work or booking a flight home, without waiting until you’ve saved up the total amount or draining your savings. Credit is almost essential for some expensive purchases, like a car or a house, as most people don’t have the cash to cover the entire cost up front.

EXAMPLE

Buying a home typically requires a mortgage because of the cost of housing—a long-term loan that allows you to buy the house now and pay over time, building equity in the process. Here is an interesting article on the average housing prices per state in 2024.

2e. Emergency Safety Net

As mentioned previously, having a credit card or line of credit can act as a financial cushion in emergencies, giving you peace of mind that you have options when unexpected costs arise, such as needing four new tires that are expensive.

EXAMPLE

Imagine you suddenly face an urgent medical expense, like surgery or an emergency room visit, costing $3,000. Your insurance covers a portion, but you’re still left with a $1,500 bill. If you don’t have that much saved up, paying it all at once could be stressful. However, if you have access to a credit card or personal line of credit, you can pay the bill immediately, ensuring you receive the care you need without delay and pay off the balance over time.

think about it

Thinking about your use of personal credit, in what ways has credit been an advantage to you? Has it helped you afford a large purchase, buy a home or a car, or pay an unexpected expense? While being in debt is never a comfortable feeling, acknowledging how the use of personal credit has been an advantage to your financial life can help you avoid feeling financial shame.

While these advantages make credit appealing, knowing the risks of spending more than you can afford is essential. Let’s look at some of the potential downsides of credit so you can use it in a healthy way and hopefully avoid some of the pitfalls.

3. Disadvantages of Using Personal Credit

Credit can be a helpful tool, but it also has its downsides that can impact your financial health if you’re not careful. It’s easy to swipe a credit card for things you want now, but the convenience can lead to interest costs piling up, tempting you to overspend or take on more debt than you can handle. This can quickly create financial stress, especially if balances grow beyond what’s easy to pay off each month. Misusing credit can lead to a cycle of debt that impacts your budget, your goals, and your overall sense of financial control.

3a. Interest Costs and Fees

Credit isn’t free money; it often comes with a cost. If you carry a balance on a credit card or have a high-interest loan, the interest payments can add up quickly, costing you more than the original purchase. We’ve already talked about the impacts of interest, but let’s review how interest impacts a purchase when you use credit.

EXAMPLE

Imagine you decide to buy a $1,000 TV using a credit card with a 20% interest rate. You plan to pay it off gradually, so you start by making the minimum monthly payments, which might be around $25 per month. It sounds manageable, but because you’re only paying a small portion of the balance each month, interest starts to add up quickly.

With a 20% interest rate, a large part of your payment goes toward interest, rather than reducing the actual amount you owe for the TV. Over time, this interest can add hundreds of extra dollars to your total cost. For example, if you keep paying only the minimum, it could take several years to pay off the TV, and you might end up spending $500 or more in interest alone, making your $1,000 TV actually cost you closer to $1,500.

3b. Overspending

Credit can make overspending easy because it removes the need to have cash to make a purchase. With credit cards, in particular, we tend to buy things we might not otherwise consider if we had to pay using cash.

Using a credit card during a sale can make it tempting to buy more, thinking you’ll “pay it off later, it will be fine.” This is especially the case with all those emails from online retailers that use persuasive language to get you to buy more. This thinking can lead to accumulating more debt than you planned over time, as impulse buying adds up quickly without the immediate impact of seeing cash leave your wallet.

hint

One trick to avoid overspending, especially online, is a 24 hr spending pause.

Here’s how it works: Whether shopping online or in person, find the items you’d like to buy. Figure out how much they cost in total. Then, simply step away from your browser window or leave the store for at least 24 hr. Really use this time to think about whether you need those items and if purchasing them will sacrifice any of your other monetary goals. After 24 hr, decide if you still want to purchase the items. Giving yourself a pause between the desire to purchase and the actual act of purchasing will help your mind sort out what you really want to spend your money on, thus limiting your chances of overspending. Give it a try the next time you feel the need to shop.

3c. Debt and Financial Stress

Unmanaged credit use can lead to high levels of debt, which can be challenging to pay off and can cause financial stress. The cycle of debt can impact mental health, relationships, and overall well-being.

Carrying a large balance on several credit cards can make it hard to keep up with monthly payments, leading to stress and possibly even missed payments, which only adds to the problem.

did you know

Studies have found that people with high credit card debt are twice as likely to experience significant financial stress compared to those with low or no debt. High credit card debt generally refers to balances that exceed $5,000–$10,000 per individual, especially if you carry high interest rates and remain unpaid. However, what qualifies as high can vary based on income, credit limits, and the individual’s ability to make payments. One thing is for sure—the constant worry about making payments, high interest rates, and accumulating balances can lead to stress, anxiety, and even physical health issues. In fact, high debt levels are one of the top contributors to financial stress, which affects not only mental health but can also impact sleep, productivity, and overall well-being.

3d. Credit Score Impact

While good credit habits can boost your credit score, missed payments, maxed-out cards, or too many credit applications can harm it. A lower credit score can make it harder to qualify for loans or secure good rates in the future.

EXAMPLE

Missing credit card payments can significantly hurt your credit score, often dropping it by 60–100 points for just one missed payment. If you are approved for a loan, you may face higher interest rates as well. For example, dropping from 700 to 580 because of missed payments can make it difficult to secure a new loan for a purchase.

3e. Identify Theft

Using credit comes with the risk of fraud and identity theft. Identity theft is when someone illegally uses your personal information, like your Social Security number or credit card details, to commit fraud or theft, often for financial gain. If your card information is stolen, this can be a hassle to resolve, and it may temporarily affect your financial health.

learn more

If you think you are a victim of identity theft, there are a few steps you should take.

• Contact the Federal Trade Commission at www.identitytheft.gov and let them know you’re a victim.
• Contact the three major credit bureaus at www.identitytheft.gov/CreditBureauContacts and ask them to put a credit freeze on your account.
• Contact the fraud department at your credit card or loan company where you believe the fraud has occurred.

think about it

Thinking about your use of personal credit, in what ways has credit been a disadvantage to you? Maybe you are struggling with credit card debt or have been a victim of financial fraud. It’s important to remember that we all make financial mistakes from time to time. Most people will experience some of the disadvantages of using personal credit, and this by no means indicates your ability to create a sound financial future.

Understanding both the positives and negatives of credit brings us to an essential question: How does credit impact your overall financial health? Credit can play a big role in your financial stability and well-being, depending on how you manage it.

term to know

Identity Theft

When someone steals and uses another person’s personal information, like their Social Security number or credit card details, to commit fraud or theft.

4. How Personal Credit Affects Your Financial Health

Personal credit can have a big impact on your financial health. Think of personal credit as a partner on your financial journey. When managed well, it’s like a helpful friend—always there to help you out when needed. Maybe you’re planning a big move, handling an unexpected car repair, or building up points for that vacation you’ve dreamed about. Credit can make these plans possible, helping you pay these expenses over time.

But like any relationship, it requires care. Without regular attention, this friendly help can quickly become a burden in terms of debt and increasing interest.

The long-term effects of credit depend on how you manage it today. Good habits, like paying off balances and using credit within your means, keep your finances flexible and your credit score strong. This opens doors to better loan terms for future goals, like buying a house or starting a business. However, falling into a cycle of debt can limit options, with high balances making it harder to qualify for new loans and increasing stress over time.

So, think of using personal credit as a balancing act. It’s a tool that can help you move toward your goals without adding financial strain. Embrace it as an ally, but always stay mindful of the promises you make when borrowing. This way, credit benefits your financial health, helping you handle life’s ups and downs with more control and confidence.

REFERENCES
Jessica Dickler (2023). Average credit card balances top $6,000, a 10-year high, as delinquencies rise. CNBC. www.cnbc.com/2023/11/09/average-credit-card-balances-top-6000-a-10-year-high.html

Jack Caporal (2024). Average House Price by State in 2024. Motley Fool Money. www.fool.com/money/research/average-house-price-state/