How Does Credit Work?

Credit has become a part of our society in almost every aspect. You want to buy a house? You need credit. Want to buy a car? Start a job? Rent an apartment? Credit. Unfortunately, many people are using credit that have never been trained on what it is and how to manage it responsibly. In this article, our goal is to explain some of the basics of how credit works and provide helpful habits to manage the money you borrow responsibly. 

What is Credit? 

Credit is using someone else’s money and paying it back over time. Most often this comes in the form of a loan. With most loans, there are generally two costs you must pay: fees and interest. Interest is the amount of money a financial institution charges for letting you use its money. These loans allow individuals to access money for various needs, whether it's purchasing a home, financing education, or covering unexpected expenses. However, this privilege comes with a responsibility to pay back what you borrow. Don’t borrow money without a realistic plan to pay it back.

Here is what it looks like in a hypothetical situation: Let’s say your friend “John” borrows $20 from you, and you both agree that John will pay you back on Friday. If John doesn't pay you back Friday, you both agree that John will have to pay you an extra dollar for every day he’s late paying you back. On Friday, John didn’t pay you back the $20, so now he has to pay you an extra dollar for every day that he doesn’t pay you back. He pays you back four days later, so he has to pay you $24 instead of $20. That $4 extra is a simplified example of how interest works. Paying later ended up costing John more money than what he initially borrowed. 

What is Your Credit Score?

A healthy credit score increases your chances for loan approval and access to better interest rates. Remember your hypothetical friend, John? What if John paid you back on the Friday he said he’d pay you back and wasn’t late? How would you rate John? Would you lend him money again? Probably so. What if John never paid you back? How would you rate him then? Would you ever let him borrow money again? Probably not. That rating is, in essence, your credit score. It tells lenders how trustworthy you are based on your history of borrowing. 

A credit score typically ranges from 300 to 850, with 850 being a perfect score. Unfortunately, you don’t start at 850. Your credit score is something you have to build, and there are lots of ways to do it. Here are a few ways to build credit: 

• Always pay bills on time
• Use a credit card and pay it off every month. If you have a balance, keep it low
• Have multiple types of credit
• Pay student loans on time
• Limit how often you apply for new loans

What is the Cost of Credit? 

Bad credit ends up costing you more in the long run. For example, let’s say that two people are planning to purchase the same used car for $15,000.

Person 1 has a credit score of 775, and because of her score, she gets approved for a 4.000% Annual Percentage Rate (APR)* for a 5-year term.  Her monthly payments will be $276.71 for 60 months and she will end up paying $16,602.60 total.  Which means she paid $1,602.60 in interest.

Now consider Person 2.  He has a lower credit score of 640, and because of his score, he gets approved for a 7.000% APR for a 5-year term.  His monthly payments will be $297.88 for 60 months and he will end up paying $17,872.80 total.  Which means he paid $2,872.80 in interest.

What are the two differences in this scenario? Their credit score and the amount paid in interest. Person 2, with a 640 credit score, will have higher monthly payments and will pay $1,270.20 more overall for the same thing. Your credit score ends up costing or saving you much more in the long run, which is why it’s important to responsibly manage the money you borrow. 

Knowledge is Power

When it comes to credit, knowledge is power. At Southside Bank, we're committed to empowering you with the tools and resources you need to build better credit habits. We’d love to sit down and meet with you at one of our many locations. Let us know when you’re ready at https://www.southside.com/resources/contact-us/. 

*This is an example only. These rates are not implied to be offered by Southside Bank for an auto loan. All loans are subject to credit approval. Please call your local Southside Bank lender to get current rates.