by Jesse Hendon
Most of us are introduced to loans in one of two ways, student loans or our first car loan. Most of us are introduced to banking through a savings account opened because of birthday money, Christmas money or our first jobs. Finally, most of us are introduced to credit through the offer of free money that just comes in the form of a plastic card! Ok, so that last one isn’t necessarily true, but that’s unfortunately how some of us saw and or see it! Let’s get into the weeds here and see the basics and how they effect our day to day lives. I think it’s important that we start with credit.
Credit is money that is borrowed with the expectation that you will pay it back. Your ability to get credit is based on your past performance as a borrower and the number attached to this performance is called your credit score. Credit can be a gift and a curse, let’s see how to use it for your benefit and how it can come back to harm you.
Credit card companies are in the business of making money. They’ll typically make money in one of two ways. The first is they charge a fee to places we buy stuff using our cards. This is typically 2-3% of the overall value of purchase. The second is from interest charged when you don’t pay your bill on time. Let’s get into the importance of this.
Credit cards can be awesome! They allow you to not have to carry cash, you can earn points on stuff you buy and use those points in the future for stuff like vacations and flights and they can help you build that credit score when used the right way.
Credit cards can also be a death spiral of debt! People will often see that limit of 5, 6, 10,000 dollars and think, well I can just pay it off in the next few months. I work hard, I deserve that new tv, table, trip to vegas or whatever else it may be. Here’s where things get tricky. Most credit cards are going to start laying that interest on the second your first bill comes back not completely paid.
Let’s say you take that trip to Vegas. You use the card to buy the flight and hotel.
Then you get there and you want a couple of drinks or to see a show or to get a nice dinner, it all adds up. By the end of the trip you’ve spent a couple thousand dollars and didn’t even realize it! Now it needs to be paid back but all you’re paycheck is already spent elsewhere.
Now you owe 20% every year on the balance and it just compounds itself over time. Then you find a card you can get a higher limit on if you transfer your current balance and it goes on and on. Nothing is free and a debt spiral can go out of control fast!
It’s important to only use credit cards for what you can pay back now. If you can’t afford it, it can wait. Use them for the points, for what they can help you with, but don’t let them use you!
If you do, getting loans for your home, cars and other big ticket purchases will be next to impossible. I think that’s a good Segway into loans and banking!
Unless you are going to live a cash only life, banks are a necessary institution. Most insurance companies require payment from your checking account. You sometimes need to send wires or cashiers checks. You also typically need a place to hold your money if your not going to live a cash existence, which most of us are not! That’s where banks come in!
How have banks worked historically? Traditionally, banks are institutions that would pay you an interest rate (percent of the money you have locked in their vaults) for you allowing them to turn around and then loan your money out to their other clients. I know, sounds risky right! Well, for most of human history it was! People lost money when banks would collapse and would never recoup.
Well, in our modern times the government stepped in and said they’d insure that money held in the vaults up to a certain dollar amount and as long as the government has money, your money is safe! So for all intents and purpose, banks are places for us to safely deposit those dollars we earn in an insured account for safe keeping. If we want access to that money it’s typically just an ATM transaction or check written away.
Now, ATMs and access to your money should be addressed here! First, I like to personally bank with big banks. They’re all over the country, I can access funds wherever I am and in an emergency they’re easier to find and deal with. When you use an ATM that isn’t owned by your bank you may be charged a fee. You should find out if this is the case for you. If it is, then pay attention to where you get that money!
Banks are also where we’ll traditionally go to for loans. Loans are borrowed money. The loan is typically for an agreed upon amount of time and the borrower (you) will pay the loaner (creditor/bank) an agreed upon interest rate for the risk the creditor is taking in giving you that money. Yes, credit cards are simply loans! They are considered unsecured loans because there is no collateral (something that can be taken back if you don’t pay). Student loans are typically the largest unsecured loans most people will take in their lives. These are typically taken from the bank of Uncle Sam. We’ll dive deep into these when we talk about education, but let’s just say be very very careful about taking a ton of money when your 18 if you don’t have a direction to go!
Banks also typically provide us loans for secured big ticket items like homes and cars. Most of our first loans are for cars! It’s important to know that you can talk to your bank about car loans and home loans to see what you qualify for and also that you can shop around for the best rate possible! Remember loans and interest work like golf, you want a lower number on your interest, not a higher!