We have talked about the basic principles of debt management in part 1 and part 2 already, with the introduction out of the way, we can now have a deeper dive into the working of debt. One of the elemental aspects of debt is the existence of credit.
What is Credit?
Before digging deeper, we need to know what credit exactly means. There have been numerous definitions for Credit but if you observe them closely you will find out that they mean the same thing. Credit is an agreement that a person has with the lender to buy a particular product or a service that he or she will pay for at a later date under agreed-upon terms. For example, if you get a loan then you will have to pay the lender with that sum along with the interest and the fees incurred on that process.
Credit can also be considered as the credit history, which the lenders typically observe to have a background check of the person and that is why it is mandatory to maintain a good credit score.
How Does Credit work?
One of the most eerily fascinating facts about the modern economy is that most of our money doesn’t even exist in reality. I am not just talking about digital money which exists, just not in a physical form. The very way money is generated is owed to credit. Credit generated by the banks in favour of corporations, government bodies, or retail debtors results in controlled inflation and allows for economic activity in the country. One of the best explainers of this phenomenon is Ray Dalio, I urge you to please watch this video to know more-
Now that we understand what credit is, we can shift our focus to –
Types of Credit
Primarily, from the perspective of a debtor, there are two major types of credit. Let’s take a deeper dive.
1. Installment Credit
An instalment credit is a credit agreement where a person agrees to repay the debt in regular instalments over a fixed period. Instalment credit can be of different periods. It may be several months or several years as well. The most popular loans such as Car loans, home loans,
Student loans, Mortgages are Instalment credits.
2. Revolving Credit
Revolving credit is a credit that lets you borrow money up to a set limit and pay it back after some time. It can give you a financial cushion for emergencies and help you manage your money. A revolving credit account sets a credit limit-a maximum amount that you are allowed to
spend on that account. You can either choose to pay the due balance in full at the end of the month or you can carry it forward to the next month.
Unlike instalment credit, revolving credit does not as such have a set repayment period and if you have no debt outstanding then you need not make any payments. One of the most popular examples of Revolving credit is Credit cards which work on the same process.
Well, What’s The Difference?
Unlike an instalment credit, Revolving credit lets you carry a balance month to month. Credit cards are a good example of Revolving accounts. Another major difference is that the Revolving account lets you decide the amount which you want to charge and the amount which you want to repay. As you keep carrying forward your balance, your interest keeps on adding up.
Although you are not required to pay off the entire balance at the end of each month, the lender will allow you a credit limit or a maximum amount which you are allowed to charge. Along with that, you will also be assigned a minimum monthly payment which varies depending on the amount of your account. The moment you miss the payments or get late, your credit score suffers.
A Note
Before ending this entry, it is important that we know why we learnt about the different types of credit. The simple reason is, this impacts you on your day-to-day life. Knowing which credit type you are utilizing can be of tremendous help to managing your finances better. In the next instalment of this series, we will dive deeper into some of the more technical aspects of debt management.