Credit and Debit 101
by Apollo Colligan
edited by Jeremy Kim
Business and Economics Club
It is vitally important to understand the other half of personal finance: spending. Spending involves the transfer of money from you to whatever service or individual you are buying from. Now, obviously, this money has to come from somewhere. There are two places from which you can obtain money for purchases: your own account or someone else’s. The first is easier to understand: my money is now your money. The second, however, forms the foundation of all financial services. It is known as debt.
Cash refers to your own money – from your account to somebody else’s.
Debt refers to using someone else’s money with the promise that you will repay them later, usually with interest (extra money in addition to the amount you borrowed as a fee).
There are different means of using either cash or debt. The most popular of these means, for smaller day-to-day purchases and occasional moderately large purchases, are debit cards and credit cards.
Debit Cards
Debit cards take your money straight out of your bank account and transfer it to whatever business you are purchasing from. There are plenty of benefits to using debit cards. You don’t have to worry about any interest payments, like you would for credit cards. You can’t go into debt, since you are limited to the amount of cash in your account. It’s easier to budget with a debit card since the money is being taken directly from your account, rather than the delayed effect of a credit card. With a credit card not removing cash from your account instantly, it tricks you into thinking that what you are spending is “free,” leading to overspending and immense credit card debt.
However, debit cards can be less secure than a credit card; since all the money available through the card is straight from your own account, banks may not offer fraud protection on debit cards. In addition, benefits such as travel insurance or rewards are only available via credit card companies.
Another disadvantage is that you cannot build your credit history with a debit card. Many situations require a good credit score, such as taking out an auto loan, submitting an apartment application, or being approved for a home mortgage. Debit cards are a great way to build a habit of financial responsibility, but ultimately, almost everybody has to start using a credit card. The most important reason why is a concept called the credit score.
Credit Score
Your credit score is the main way in which a loaner will judge your creditworthiness: the perceived ability for you to repay a loan. Credit scores range from 300 to 850: the higher your score, the more trustworthy you have shown yourself to be in repaying your debts. Your credit score is judged based on a few factors:
The amount you currently owe: your debts
New credit: credit inquiries made in the past 12 months
Length of credit history: how long you’ve been borrowing
Credit mix: the types of credit you have whether from credit cards, loans, mortgages, etc.
Credit history: how reliable are you at paying back your loans and debts
It is important to maintain a high credit score. The best way to do this is by making your credit and loan payments on time. Most debts and loans are paid in installments, like a student loan or a mortgage. When paid on time, you are actively proving to financial institutions that you are a responsible borrower, thereby increasing your credit score. Meanwhile, missing or being late for just a few payments can drastically decrease your credit score, so it is important to remain perpetually vigilant and responsible in your resolution of debts.
Credit Score Rundown
Credit
Credit, unlike debit, takes money from a credit card company (often a bank) with the promise that you will repay the bank at the end of the month, plus interest if you don’t pay off the entire amount by the next billing date (interest rates vary depending on the terms of the card). Credit cards are powerful, but they come with many disadvantages.
The most clear disadvantage is that you can too easily miss a payment, putting you in debt and lowering your credit score. The average interest rate for credit cards is a very high 20%, meaning it is generally more expensive to use a credit card than a debit card. If possible, it’s best to pay off your balance each month and not carry over a balance. Sadly, with the compounding interest added to your balance for each billing period, the purchase price for an item can ultimately double by the time you’ve paid it off if you only pay the minimum due each month. It also may be difficult to budget without the impact of money leaving your account with each purchase. For those with their first credit card, it can be too tempting to just swipe their card for purchase after purchase without keeping track of how much is being spent.
However, once a sense of responsibility and self-control has been developed, credit cards will build up that credit score mentioned earlier. In addition, if your credit card is stolen and used, you can also easily chargeback the card and get a new one at no detriment to you. Banks also usually offer benefits for a credit card, such as additional miles on a certain airline, gifts or rewards, cash back, or perks at certain establishments, such as access to airport lounges.
Getting a Debit and Credit Card
If you are under the age of 18, you might not have a credit or debit card of your own. However, this will quickly change as you move into the later years of high school and enter college. The best way to develop sustainable spending skills is to start with an authorized debit or credit card linked to your parents’ accounts. Although authorized credit cards will not increase your credit score, it will be helpful practice in establishing healthy spending habits. Discuss with your parents and learn about the viability of having an authorized card.
Following your graduation, you can start using a college-student-specific credit card, which offers you the ability to start building your own credit score and provides a more thorough and realistic introduction to spending compared to an authorized-use card. However, these introductory credit cards offer fewer benefits and have generally higher interest rates than regular credit cards because you don’t yet have any credit history. But remember: if you pay off your total balance for each billing cycle, you won’t have to pay any interest!
Image source: Fiji Sun
Key Vocabulary
Debit Card — Cards that use cash directly from your checking account.
Checking Account — A low interest account used for financial transactions.
Credit Card — Cards that use cash from the credit card provider under the promise that you will repay the provider with interest.
Interest — A percentage rate paid based on an original cash amount. Credit cards have an interest rate of around 20%
Credit Score — The primary measure of credit trustworthiness that banks and lenders use to determine the conditions of a loan. The higher your credit score, the lower rates and better terms for a loan you will get.
Repayment Requirement — Amount needed to repay at the end of a given term.
EMI (Equated Monthly Installment) — A specified payment made by a borrower to a lender at the end of each month specifically used for the financing of large purchases. This allows the borrower to purchase something expensive over time.
Overall, learning and attaining the skills of credit and debit card usage is one of the most important factors in finance. Start early and master quickly.