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An introduction to borrowing money, credit scores, and the cost of debt.
Imagine two people buying the exact same 450 a month, while the other pays $600 for the same vehicle. Why? The answer is a hidden three-digit number that follows you everywhere you go.
A credit score is a three-digit number (usually between 300 and 850) that tells lenders how likely you are to pay back borrowed money. Think of it as your 'Financial GPA.' It is calculated using five main categories: Payment History (35%), Amounts Owed (30%), Length of Credit History (15%), New Credit (10%), and Credit Mix (10%). A high score means you are a 'low-risk' borrower, which grants you access to lower interest rates. Conversely, a low score can prevent you from renting an apartment, getting a cell phone plan, or buying a home. The most important rule? Always pay on time, as your payment history is the largest slice of the pie.
One of the biggest factors in your score is Credit Utilization, which is the percentage of your total credit limit that you are actually using.
$L = \$1,000B = \ on that card.
3. To find your utilization rate (), use the formula: Quick Check
If you have a credit limit of 1,000, what is your credit utilization rate, and is it within the recommended range?
Answer
The utilization rate is 50% (2,000), which is above the recommended 30% limit.
When you borrow money, you don't just pay back what you spent; you pay interest. The Annual Percentage Rate (APR) represents the yearly cost of the loan. Different types of debt have vastly different 'prices.' For example, Student Loans and Mortgages are often considered 'good debt' because they have lower APRs (typically to ) and help build long-term wealth. Credit Cards, however, are high-interest debt, often carrying APRs between and . If you carry a balance on a credit card, you are essentially paying a premium for every item you bought, making that 'sale' item much more expensive in the long run.
Imagine you buy a $\$1,00024\%$ APR.
$\$1,0002\%24\% / 12$ months).
3. In the first month alone, you owe: $\$1,000\ total.Quick Check
Why is a 5% interest rate on a car loan better than a 22% interest rate on a credit card?
Answer
A lower APR means you pay less 'extra' money to the lender over time, making the total cost of the purchase lower.
The debt cycle happens when interest grows faster than you can pay it off. To avoid this, financial experts suggest two main strategies. The Debt Avalanche method focuses on paying off the debt with the highest interest rate first, saving you the most money over time. The Debt Snowball method focuses on paying off the smallest balance first to build psychological momentum. Regardless of the method, the goal is to pay more than the minimum payment. The minimum payment is designed by banks to keep you in debt for as long as possible while they collect interest.
You have two debts:
- Debt A: $\$50025\%\ at APR (Student Loan)
1. Identify the 'expensive' money: Debt A costs cents for every dollar borrowed per year, while Debt B only costs cents. 2. Even though Debt B is a larger total number, the Avalanche Method dictates you put every extra dollar toward Debt A first. 3. By killing the interest rate first, you stop the fastest-growing 'leak' in your bucket.
Which factor has the largest impact on your credit score calculation?
If you have a debt with 20% APR and another with 5% APR, which should you pay off first to save the most money?
True or False: Using 90% of your credit limit is a good way to build a high credit score.
Review Tomorrow
In 24 hours, try to list the five factors of a credit score and recall which one is the most important.
Practice Activity
Look up a 'Credit Card Interest Calculator' online. Plug in a 50 minimum payment.