As part of the Investment Basics series we have discussed to date several elements of investing including the role insurance plays in your financial independence. We have also discussed the investment pyramid and how a diversified portfolio, as well as a steady and consistent investment plan, can lead you to obtaining your retirement goals. The next few articles are on the basics of credit and the role it plays in your financial picture.
The big picture
The credit world is a never-ending cycle of borrowing and lending money people do not have but expect to have in the future. Our society has a lot more “buying power” than ready cash. As long as you faithfully repay what you borrow, your lenders will also pay back what they borrow and the cycle will continue. This is a very delicate system, however, and each time someone breaks a promise by not making a payment or for some other reason there is a loss of faith in someone making their payment, the system suffers because the entire system is based on trust and credibility.
There are five major players in the credit arena. The first are the buyers who are businesses and people like you who want to buy a product or service that costs more than you are willing or able to spend for it using cash. You would then seek out a lender who will loan you the money and charge interest in return for the privilege of using their money. This is the way credit cards, car loans and lending banks work.
The next players are the sellers. These can be store owners and/or service providers who need to make sales to stay in business. Some sellers offer loans to customers. Others arrange for their customers to get loans from an outside lender, (often getting a commission on the referral), and still others are credit card companies who basically front the money directly to a buyer. In any case, at the time of the sale, little or no cash changes hands, but the seller can record a sale and lenders can record new loans.
Lenders who make loans and charge interest, do so based on the trust that their borrowers will repay faithfully, (this is also called good faith lending). Then they need to raise more cash to be able to make more loans and stay in business until these loans are repaid. Lenders also borrow money from other lenders and, if they are a bank, they can also borrow directly from the federal government.
Note: the prime rate is the rate that the banks charge their best customers which are typically very wealthy customers. They then charge a higher rate which is prime plus a certain percentage based on that person’s credit worthiness. The discount rate is the interest rate that the Federal Reserve Bank charges other banks. It is always lower than the prime rate so that the banks are assured of borrowing at a lower rate and lending at a higher rate. This “spread” is where the banking industry makes some of their money.
The federal government’s bank, called the Federal Reserve Bank, lends money to banks specifically to supply them with enough cash to stay in business. The “Fed” makes the loans based on the trust that the banks will repay faithfully, which partly depends on the bank’s borrowers, like you, repaying them faithfully. The Fed, however, must also get money from somewhere. They can print more, get it from taxes, and borrow it.
The final piece is the role that businesses and individuals play in lending the federal government money with their purchase of Treasury bonds and securities. When a bond is purchased you are actually lending the bond issuer money and expecting to be repaid on a schedule with interest over time. The government adds a bonus by allowing the interest earned from the loans you make to be tax exempt. They then use that money to repay money that is borrowed. As you can see this is a giant revolving cycle with many key pieces that need to stay intact to function correctly.
People who repay faithfully and do not overextend themselves are rewarded with better credit and this in turn makes it easier for them to borrow again. The Federal Reserve is backed by the “full faith and credit” of the federal government or in other words, we are asked to have complete faith in the government’s credit worthiness that it will repay what we lend it.
The concept of credit
When people or businesses lend you money they believe that you will repay them. Credit originates from the Latin word meaning “credo” which means “I Believe”. The credit system is available to everyone as long as you faithfully payback your debts. If abused, the credit system can cost you hundreds, if not thousands of dollars every year.
There are four keys pieces to the credit game:
As you can see, the credit cycle and understanding the basic elements of credit are vitally important to you and your lifestyle. It is important to live within your means and to be cautious not to get into excessive debt. If you are in excessive debt you should seek the advice of a qualified financial advisor to assist you in determining the best alternatives to resolve your debt problems. In the next article we will discuss your credit profile and understanding the credit reporting system.