Remember that credit is like a grown up IOU? So let's go over the most common form of credit (IRL they are called lines of credit) so you can be a professional credit card user.
Credit cards. These are probably the most common form of credit you know about. You may even have a credit card right now! When you open a credit card, you will get a credit limit. That credit limit gives you a monthly cap on how much you can spend (wah wah). As you make purchases throughout the month, they go onto your credit card statement. The statement is a big tally of all the purchases made on your credit card for the last billing cycle (which is usually a month). Once your bill comes, you're on the hook for the whole tally, and you want to pay the whole tally every time. Don't ever carry a balance (aka: leave money left unpaid) if you don't absolutely have to. Here is the kicker though– the money doesn't come out of your bank account at every purchase like when you use a debit card, and it definitely doesn't fly out of your wallet like cash does. At the end of the month you'll get a big bill with all of your purchases on it to be paid in one lump sum. And if you can't pay that big lump sum? Then you make smaller payments and then are charged interest. This is called credit card debt.
So let's say you get yourself a credit card. You treat yourself to a new outfit, some food out with friends, gas tank fill ups, movie nights, video game purchases, and all sorts of goodies. These things are added up on your credit card statement. While you're buying this, you look at your checking account to see your balance/look in your wallet for some cash, but it looks like you haven't made a dent. Sweet! (Remember the people who tried to scare you away from a credit card? THIS IS WHY. Be smarter than these people!)
See, this is where people get into trouble. They spend tons of money, but because they don't see their account balance go down, they think they have way more money than they really do. So they keep spending it. They're walking along all happy and thinking they're rich, then BOOM. They're hit with a bill with all of those purchases tallied up. Now all of the money they thought they had sitting pretty in the bank now has to go toward stuff they already paid for. Talk about a sucker punch. Sometimes, the spending can get so out of control that you don't have enough in your account to pay for it all, that it will take two months of income to pay off one month's spending spree. When that happens, you are charged interest. Interest is kind of like a late fee, it is a percentage of your bill added on to what you already owe. Let's look at an example.
You have $100 in your bank account.
You spend $500 this month on who knows what (you weren't keeping track. C'mon man! Remember your budget!)
What is $100- $500? -$400. NEGATIVE $400. That means once you clear out your bank account, you still owe $400 to the credit card company. Bummer dude. You decided to put that card away and don't charge anything to it until your balance is paid off.
But wait, what's that 24% interest rate at the bottom of your bill? That means that because the credit card company is being super nice (they're not) by only letting you pay part of your bill, you're giving a (mandatory) 2% tip for every month you don't pay off that extra balance. (The 24% interest rate is per year, so if you divide that by the 12 billing cycles/months per year, you pay an extra 2% each month. Just trust us).
So you still owe $400 to the credit card company. Plus interest for every month until it is paid off.
So by the end of all this, you paid $521.79. It took you over 5 months of clearing out your account to pay for one shopping spree. Worth it? Probably not.
Don't even get us started on what happens if you run up a balance and forget to pay it off. Spoiler alert: you pay the interest on the whole bill until you remember. Super ouch.
Here's the deal though: this doesn't have to be the way. You don't have to be scared of credit cards. There's something magical in this world called technology. You have the power to check your credit card statement at any time of day and look into your balance, so you never need to be caught off guard! There are autopay features to make it so your credit card is paid off automatically at the end of the month. You can pay off every purchase immediately so you see your bank account change with everything you buy. You can have one that you only use for emergencies! Shocker!
Basically, having a credit card is like having a super power. "With great power comes great responsibility." Got it, Peter Parker? In the next few lessons we'll talk about other ways you can use credit, and the pros verses cons of using it. Stay tuned!