Episode 7: What is credit, and how do I optimize it?

Credit is one of those financial concepts that can get very confusing, very quickly, but it's one that you will run into many, many times in your lifetime. Let's think of credit as intentional debt - when we need something we can't exactly pay for upfront, we take out a loan for it from a person or an institution. Let's say you borrow from a friend - the reason why they'd be willing to give you that loan is because you're trustworthy to them - maybe you've known them a long time, have had many experiences with them, and you've proven that you know how to use money wisely. As such, they'll trust your promise to give you their money back.

Unless the person that's giving you a loan is that aforementioned best friend or family member, it's unlikely that they'd just give you a loan for no reason, right? If they don't know you, not only do they not have the guarantee that you'll return their money, they also don't have a particular motivation to give you money that they could just spend on something else. Why would they just let you borrow money?

That's where interest comes in - having an interest rate, or a percentage of the loan that you have to pay back extra - becoming an incentive for people and organizations to lend money. That's the basic concept of credit - where you are essentially taking out somebody else's money, and giving it back...but with a little extra.

There's two main types of credit - installment credit and revolving credit. Installment credit is what we talked about in Episode 7. Basically, it's when you take out a big sum of money and pay it back in installments over time, like a mortgage or a car loan. Revolving credit, on the other hand, is about smaller loans you take out and payback on a regular basis - like your credit card. On a credit card, you can spend up to a maximum (your credit limit) every month, and then repay it at the end of the month to not accrue interest.

Revolving credit operates in lines. A line of credit is basically the maximum amount that you can spend on something. Unlike installment credit, however, you don't have to pay interest on all of it - just what you spend. On a credit card, for example, you don't actually have to pay your credit limit $3000 dollars every month if you only spent $100 on groceries.

Usually, with revolving credit, there's a certain period of time before you actually have to pay interest on anything you haven't covered. For example, for a credit card, you typically have to pay the full credit bill at the end of the month, or it will start collecting interest. One way you can measure interest is through the Annual Percentage Rate, or APR - that's how much interest is accrued on your principal balance every year. Always check the interest rate on a card and the period of time you have before you have to actually pay your credit card bill.

Outside of credit cards, there are other types of revolving credit lines that exist:

• A Buy-Now Pay-Later (BNPL) or refinancing option - that's when you buy a specific item on credit and pay it back in installments. Think Afterpay, Affirm, Payl8r or Klarna
• A Home Equity Line of Credit (HELOC): That's when you turn your home equity, or the value of your property, into collateral for credit. In plain English, that's when you take the value of your house and borrow money from it, with the condition that you could lose part of the ownership of your house if you don't pay it back
• A Personal Line Of Credit: A very rare type of loan with completely varied terms and interest rates, where you can take out credit with a bank

Credit cards come from banks or from credit unions, which are typically owned by individuals as shareholders and essentially involve the redistribution of money on credit cards. As long as they are secure, and have a strong reputation, credit cards from these financial institutions are typically not very risky.

All credit carries a level of risk - you're borrowing money, and you might have to pay back even more money in the future. Plus, you have to be cautious to make sure you're following deadlines and not missing payments so they don't accrue interest. For secured lines of credit that are backed up by some kind of property that you own (like a HELOC), you might even run the risk of losing your property! So why might people choose to actually pay for things using a line of credit, especially a credit card, instead?

Here are some of the benefits of using credit over simply paying with cash or debit:

1. Timing: If you only receive your paycheck on a monthly basis, and you're buying groceries every week, it makes sense to put your groceries on a credit card and pay the total cost of groceries at the end of the month from your paycheck, saving you overdraft fees
2. Financial Safety: credit cards can protect you from financial fraud, since when you fall victim to a scammer, your financial institution will be much more likely to reverse the transaction and protect the money, since it's their money until you pay the credit card bill
3. Benefits: Financial institutions are aware of the risks that you have when taking out credit - that's why some cards will offer various benefits, such as a cashback, where you can get 1-3% of your money back, or a points system you can use for benefits

But by far the best advantage of using a credit card is the effect it has on your credit score.

Hold up. I just pulled up with a word you may not have heard in the entirety of your short life so far. What's a credit score?

Well, let's go back to the actual concept of credit. The entire system works on trustworthiness - if I trust that you'll give me my money back, I'll lend you money. Sounds pretty simple, right? But how can a financial institution, with millions of people asking them for money, actually determine who's trustworthy and will pay back their bigger loans, like a mortgage or an auto loan? They can't run background checks on every single person - that would take a lot of time and a lot of money, and probably have a level of subjectivity and comparison bias.

Instead, banks use smaller, short-term credit, especially revolving credit, as a measure of your financial trustworthiness to then qualify you for long-term installment credit, like for houses and cars. Basically, they look at how good you are at paying off the smaller amounts of credit that you take out, especially through your credit card, along with a number of other factors around the way you use your credit card, quantify it based on how positive those behaviors actually are, and then score you on it. As such, your effective use of revolving credit is actually a test to see how good you are at using credit. Just like any other test, there is a numerical score attached to it, that lets a business compare you to others. This score is known as a credit score.

It's a pretty logical system - people with a high credit score, who basically pass the test for proper credit utilization, are the ones that will qualify to receive even more money, the same way that by doing better in school, teachers are more likely to give you higher predicted grades for AP, IB, CSAT, GaoKao or A-Levels, even when you haven't actually gotten them yet. But for a test, you get a curriculum beforehand, you know the exact skills and knowledge you need to practice to do well in the subject, and you have lots of room for error. Credit scores, on the other hand, are built throughout your lives, based on your long-term behaviors.

This is where things get complicated. Different countries have specific laws and regulations around what can go into the actual credit score calculation. Within a country, different credit reporting agencies will have their own special equation that they'll use to determine how much in credit you should receive. In some places, it's normal to factor your income majorly into a credit score, but in others, it's not even considered a factor! When taking out a credit card and building your credit, it's important to check which credit reporting agency works with your financial institution to actually score you. Then, do a little research to find out what that credit score includes, and make sure to stay on top of those specific things. Here are some general factors that often pop up on credit score calculations:

• Payment History: This is just your track record of paying credit card bills - have you accrued interest? Have you made payments?
• Credit Mix: These are the different types of credit you have - student loans, home loans, credit cards, etc- having a varied credit mix helps you prove you can actually stay on top of multiple commitments
• Amounts Owed: This is the amount of debt you have in a particular moment from both installment credit like loans and revolving credit like credit cards. Paying back loans as fast as possible can ensure that outstanding loans aren't factored into your credit score. This also means keeping up with monthly payments for home loans and student loans, even if you can't instantly pay back the full amounts
• Credit Utilization Rate: This is the amount of your credit limit that you actually use on a regular basis. For example, if your limit is $4000, but you only spent $400 every month, your utilization rate would be 10%. Typically, having a utilization rate of 30% can contribute positively to your credit score
• Length of Credit History: This is how long you've been using credit - having a long credit history can actually help you score higher, which is why using credit cards early is so useful!
• New/Open Credit: The amount of credit cards you have open, especially if they were opened within a short period of time. Limit the number of credit cards you use to the ones you actually need and consistently get benefits from to also do better on benefits

When opening a line of credit, it's important to understand that credit is a privilege that comes with risks. The people giving you credit are not simply giving you money for no reason, they also want to make a profit. That's why there's a number of factors to consider when actually getting a credit card:

1. Fees: Some credit cards will charge an annual fee to maintain, especially if they have particularly significant perks - if you're not using the credit card enough to claim the benefits, this annual fee would be entirely useless
2. The Payment Network: All credit cards will use some form of secure payment network that will take a little commission for ensuring that a transaction goes through - like Visa or Mastercard
3. Interest Rate: A high interest rate can turn accidental credit card debt into something much more serious and sinister - look out for overly high or unplayable interest rates, especially if you sometimes miss your payment

At the end of the day, your use of credit is up to you. There's many, many different options out there, and each of those options are quite different depending on where you are and how important building credit is for you. When deciding on credit, just think about whether or not the perks of using a credit card for you outweighs the potential risks of debt, and how important your credit score will be in the future. As we move into adulthood, starting early with credit is a great way to get ahead of the curve and start building up our creditability!