7.3: Credit

Learning Objectives

1. Identify different types of credit and their structural features.
2. Evaluate the costs, risks, and benefits of using credit.
3. Apply maturity matching and credit management strategies to real-life decisions.

Borrowing with Strategy

What Credit Really Is

Simply put, credit is borrowed money. But it’s also borrowed trust. When you use credit, you’re not just spending money you don’t currently have; you’re promising to repay it, usually with interest, on a future schedule.

In everyday life, credit smooths the gaps. It allows you to access things, such as cars, education, or even lunch, without having to pay the full amount upfront. But credit isn’t free, and it isn’t magic. It has structure: principal, interest, terms, and payments. And when misunderstood, it has consequences.

To use credit well, we need to look under the hood.

The Building Blocks: Principal, Interest, Term, and Payment

Every form of credit is built from four core parts:

• Principal – The amount you borrow
• Interest – The cost of borrowing, expressed as a percentage
• Term – The length of time you agree to repay
• Payment – The amount due at each interval (usually monthly)

Together, these determine the total cost of credit. The longer the term, the more interest you usually pay. The higher the interest rate, the more expensive it is to borrow, even if the principal seems small.

Understanding these components makes it easier to compare offers, anticipate tradeoffs, and manage repayment without surprises.

Types of Credit

Credit comes in different formats depending on how it's issued and repaid:

• Installment credit involves borrowing a set amount and repaying it over time in fixed installments. Mortgages, auto loans, and student loans fall into this category. The terms are clear, the payments are structured, and the debt is paid off over time.
• Revolving credit lets you borrow up to a limit, repay what you choose, and borrow again. Credit cards are the classic example. There’s flexibility but also risk. Interest is charged on what you don’t repay, and balances can persist.
• Secured credit requires collateral, an asset that can be reclaimed if you fail to repay. This lowers the lender’s risk (and your interest rate), but increases your personal exposure.
• Unsecured credit is based solely on trust, including your credit score, income, and credit history. Credit cards, personal loans, and most student loans are unsecured. Because there's no collateral, rates tend to be higher.

Different tools serve different goals. Choosing the right one starts with knowing what you're really borrowing and why.

Cost of Credit: Interest, APR, and Compound Trouble

Interest is the fee you pay to borrow. It’s often expressed as an APR (Annual Percentage Rate), which includes not just interest but also fees that affect the loan’s actual cost.

Compound interest, especially on credit cards, means you’re charged interest on your interest. That’s how a $300 purchase can become a $500 balance if paid slowly over time.

Making only the minimum payment may feel manageable, but it dramatically increases the total cost. Your balance shrinks slowly, if at all, and the lender profits while your progress stalls.

Credit Reports and FICO Scores

Your credit behavior is recorded, scored, and shared. That record, your credit report, is maintained by three main bureaus: Equifax, Experian, and TransUnion. Lenders report your payments, balances, and account activity to these agencies.

From this data, your FICO score is calculated. Ranging from 300 to 850, it reflects your trustworthiness as a borrower. Five core components shape your score:

Payment history (35%)

On-time payments matter most.

Amounts owed (30%)

Also called utilization: how much of your available credit you're using.

Length of credit history (15%)

Older accounts show experience.

Credit mix (10%)

Having both installment and revolving accounts helps.

New credit (10%)

Opening many new accounts at once is risky.

Your FICO score influences what you can borrow, how much it will cost, and whether doors open or stay closed.

Maturity Matching: Timing Matters

Smart credit users align their purchases with how long they expect to take to pay them off. This is called maturity matching.

Use short-term debt (like credit cards) for short-term purchases like groceries or fuel. Use longer-term loans (like installment credit) for long-term assets like a car or education.

Problems arise when people mismatch their financial commitments, putting a wedding on a credit card and paying it off over five years, or financing a phone for 24 months when they’ll upgrade in 12. You're still paying long after the value has disappeared.

Credit as a Strategic Tool: A Real SWOT Analysis

Let’s examine credit with a strategic lens by identifying its Strengths and Weaknesses as well as exploring the Opportunities and Threats (SWOT Analysis) it presents:

Helpful

Harmful

Internal

Strengths

Credit expands access. It helps build financial history, smooth income variability, and offers fraud protection and travel perks. With responsible use, it opens doors to car loans, home mortgages, and even better insurance rates.

Weaknesses

Credit makes overspending easy. The gap between what you can buy and what you can afford becomes invisible. Interest can silently grow a balance into something unmanageable.

External

Opportunities

Credit can be leveraged for major purchases, used to seize time-sensitive opportunities, or as a buffer in emergencies when cash falls short. Responsible users build positive credit signals without carrying debt.

Threats

High-interest debt, late payments, and credit dependency can trap users in long-term cycles of debt. One emergency (job loss, medical issue, identity theft) can drag down a score and raise future borrowing costs for years.

Credit is powerful, but only when used with clarity.

Building and Managing Credit Intentionally

Want to build credit from scratch or intentionally rebuild it? Here’s how:

1. Start with a secured credit card, where your deposit becomes your credit limit. It’s a training tool and trust builder.
2. Use it monthly for small expenses, like a streaming subscription or gas, and pay the full balance on time.
3. Pay in full, not just because it’s responsible, but because it avoids interest, aligns with maturity matching, and sends the strongest signal to lenders.
4. Keep your utilization low. If you have a $1,000 limit, don’t carry $700. Stay under 30%, ideally under 10%.
5. Don’t open too many accounts at once. Every inquiry is recorded, and excessive activity can spook lenders.
6. Use autopay wisely, not just to avoid late fees, but to build consistency. If you're forgetful, automation is your ally.

Finally, check your credit report once a year at AnnualCreditReport.com (www.annualcreditreport.com). It's free, it’s your history, and it helps you spot errors before they become problems. Your credit history is a portrait of how you manage your financial commitments. Make sure the picture is one you’re proud of.

Summary

Credit is borrowed trust, not free money. It lets you act today using tomorrow’s income, but that power comes at a cost. This section breaks down principal, interest, and repayment terms, introduces the FICO system, and compares credit structures. Readers explore how to use credit as a lever, not a trap, and how alignment, visibility, and responsibility shape long-term outcomes.

Exercises

1. What kind of credit do you already use? How does it shape your daily decisions?
2. What makes it hard to pay off a credit card once it starts carrying a balance?
3. Compare snowball vs. avalanche payoff methods. Which feels more motivating and why?