Simple Guide to Understanding Credit Basics

In order for a consumer to become a productive contributor to the economy, it is essential for him/her to understand the fundamental principles surrounding the use of credit. It is uncommon for an individual to possess the financial funds that are necessary to partake in essential and desired transactions.

Most individuals will be required to utilize credit at some point in their lives. Whether they want to purchase a house or have backup resources in the event of an emergency, consumers will need to become aware of the proper way to utilize credit. If an individual is irresponsible with the credit he/she obtains, he/she may experience protracted, detrimental effects of his/her behavior. Understanding the basic uses and conditions of credit is the first step in developing responsible borrowing techniques.

Background

Credit is an essential part of the United States economy, and it is pertinent to the everyday lives of consumers. Therefore, it is important for individuals to understand the fundamental aspects of credit, as well as the uses of loans, and the benefit of establishing credit. If an individual wishes to make large purchases, such as a home or motor vehicle, he/she will be required to apply for a loan. However, in order for an individual to be granted a loan, he/she must first establish a positive credit history. The easiest way to achieve this is by obtaining a credit card.

Consumers should be wary of the dangers of credit card abuse, though. If an individual fails to responsibly manage his/her credit, he/she may experience adverse repercussions for his/her behavior. Still, if a debtor successfully adheres to his/her credit contract, then he/she will develop an exceptional credit history, which should be reflected on his/her credit report.

Uses of Credit

The idea of becoming dependent upon credit cards often causes consumers to experience fear and anxiety. Credit cards are often perceived as dangerous. This is because many individuals are unaware of the proper way to utilize a line of credit, and therefore, they accrue more debt than they can manage. This may result in loan refinancing or bankruptcy. However, it is important for consumers to understand that, when used the right way, credit cards may be critical to an individual's future.

In order for an individual to obtain large loans, he/she will be required to have a positive credit history. Without an adequate credit report, an individual will be unable to obtain a home, a car, or essential utilities. In some cases, lack of a credit history will prevent an individual from being offered employment. If a consumer wishes to rent an apartment or secure a cell phone contract and he/she has not established a credit history, then he/she may be denied, or he/she may be required to pay a larger deposit for these assets.

Credit Contract

Whenever a consumer enters into a financial agreement, he/she will be required to sign a legally binding credit contract. When entering into a credit contract, it is essential for an individual to carefully review all of the terms and conditions related to the agreement, as he/she will be literally bound by it. Conflicts between lenders and borrowers often arise because the debtor fails to understand all of the terms of the contract.

A credit contract will include a great deal of information pertaining to a borrower's financial obligations. It will detail specifications about the loan, as well as the repayment responsibilities of the borrower. An individual that is entering into a credit contract should make a copy of the documents to keep in a file. This will ensure that the debtor has access to all of the original and accurate information regarding the loan, in the event that a dispute arises.

Credit Insurance

Lending credit to consumers is very risky for banks and credit unions. In many cases, they grant applicants unsecured loans, in which there is no guarantee that the lender will ever receive compensation for the loan.

If an individual experiences financial difficulty and has trouble repaying his/her debts, a creditor may never be paid for the loan that they extended. Therefore, many lenders choose to obtain credit insurance so that they receive compensation in the event that a borrower defaults on a loan or files for bankruptcy.

Business credit insurance can help to make loaning less of a risk for banks and credit unions. Credit insurance is also beneficial for borrowers. An individual that obtains a loan may choose to purchase insurance on that loan.

Therefore, if a consumer experiences unexpected and extraneous circumstances that makes it difficult for him/her to meet his/her financial obligations, credit insurance will ensure that the borrower's bills continue to be paid. This is necessary because failure to make a monthly payment may result in a low credit score, which may be detrimental to a debtor's financial future.

It is illegal for a creditor to require a borrower to obtain credit insurance, as is including insurance in a borrower's monthly payments without his/her knowledge. However, credit insurance may have important benefits for both consumers and creditors, and an individual may wish to purchase this insurance for added assurance.

Promissory Notes

Often, an individual is unable to obtain a loan from a bank or a credit union because he/she has not established a positive credit history. If an individual is not deemed to be creditworthy, a lender may charge the applicant exorbitant interest rates. Therefore, it may be worthwhile for a consumer to seek alternative forms of credit.

One type of credit that few people consider are promissory notes. A promissory note functions in the same way as any other loan. A loan will be granted to an individual by a lender. In return, the borrower will be required to repay the loan with interest.

A promissory note will detail all of the aspects of a financial agreement, including payment obligations and the specified interest rate. A promissory note may not only be important for individual consumers seeking a loan, but also for a business that will not be granted further loans.Without access to financial funds, a business cannot effectively operate.

Credit Default Swaps

When reviewing information about credit default swaps, a consumer may become extremely overwhelmed. The available information is often difficult to understand, unless an individual has a financial background.

However, the concept behind credit default swaps is quite simple. A credit default swap functions much the same way that credit insurance does. In order to protect his/her investments, an individual may purchase a credit default swap from a bank. This will help to ensure that an investor is compensated in the event that a borrower defaults on a loan.

When individuals purchase a credit default swap from a bank, they are essentially purchasing insurance. If a borrower is unable to repay a loan, the bank will be required to compensate the lender for the money that he/she lost.

When the concept of credit default swaps was first established, it presented very few problems, and it was beneficial for banks and credit unions. However, since the economy has become increasingly unstable, the disastrous potential of this type of insurance has become evident. As the current financial crisis continues, credit default swaps may create more and more problems for an already struggling economy.

NEXT: Terms of Credit Overview