Americans use credit to make many purchases . The total amount of funds borrowed and lent each year is enormous. In addition to individuals borrowing funds, the federal, state, and local governments all borrow funds, too. The nation’s economy, in fact, depends on individuals and groups being able to buy and borrow on credit.
In this section, you’ll learn what credit is and why people use it.
Credit and Installment Debt
The price of credit is the interest charged on the amount borrowed.
Economics & You Have you ever purchased something using credit? Why or why not? Read on to learn about the price of credit.
Credit is the receiving of funds either directly or indirectly to buy goods and services today with the promise to pay for them in the future. The amount owed—the debt—is equal to the principal plus interest. The principal is the amount originally borrowed. The interest is the amount the borrower must pay for the use of someone else’s funds. That “someone else” may be a bank, credit union, credit card company, or store.
Any time you receive credit, you are borrowing funds and going into debt. Taking out a loan is the same as buying an item on credit. In both cases, you must pay interest for the use of someone else’s purchasing power.
One of the most common types of debt is installment debt. Consumers repay this type of loan with equal payments, or installments, over a period of time; for example, 36 equal payments over 36 months. Many people buy durable goods, or manufactured items that last longer than three years, on an installment plan. Automobiles, refrigerators, washers, and other appliances are considered durable goods. People can also borrow cash and pay it back in installments. Figure 4.1 below shows the growth in consumer installment debt.
Figure 4.1 Increase in Borrowing
More and more Americans are choosing to buy durable goods on credit .
Figure 4.2 Pay Now or Pay Later?
Say you want to borrow $1,000 to buy a flat screen television. Your monthly payment will be lower if you choose the 36-month loan over the 24-month loan. The amount of interest you pay, however, will be higher.
The length of the installment period is important in determining the size of the borrower’s monthly payments and the total amount of interest he or she must pay. A longer repayment period results in a smaller monthly payment. For example, Figure 4.2 above shows that if the repayment of a loan is spread over three years (36 months), the monthly payments will be smaller than if the loan were repaid in two years (24 months). There is a trade-off, however. The longer it takes to repay an installment loan, the greater the total interest the lender charges, and so the total payment will be greater.
The largest form of installment debt in this country is what people owe on mortgages. A mortgage is an installment debt owed on real property—houses, buildings, or land. Interestingly, most people who owe a mortgage on their home do not consider themselves deeply in debt. Because people must have housing, they think of a mortgage as being a necessary monthly payment not similar to other kinds of debt. A mortgage is a debt, however, because somebody has provided the owner with funds to purchase property. In return, the owner must repay the loan with interest in installments over a number of years. As with other forms of installment debt, the longer the repayment period is, the greater the final total payment will be.
Why People Use Credit
The use of credit allows the borrower to enjoy consumption now rather than later.
Economics & You Imagine that you want to buy a new car. Would you rather use credit to buy it now, or save your money and pay cash for it later? Why? Read on to learn about why people decide to use credit.
Many things that Americans buy on credit are “big-ticket” items—products such as automobiles, electronics equipment, and major home appliances. People often feel forced to buy such items on credit because they believe these products are essential and they want them immediately. They do not want to wait. Of course, consumers are not really “forced” to buy most goods and services on credit. They could decide instead to save the funds needed to make their purchases.
Some might say that you would be better off saving and waiting to buy a pickup truck, for example. During the years you are saving for the truck, however, you forgo the pleasure of driving it. Many people do not want to postpone purchasing an important durable good. They would rather buy on credit and enjoy the use of the item now rather than later. Another reason for going into debt is to spread the payments over the service life of the item being purchased. For example, people do not buy a truck or car to have it sit in the garage. What they buy is the availability of the vehicle each day, week, month, and year that they own it.
Figure 4.3 Buying on Credit
No hard-and-fast rules can tell you whether or not to buy on credit. This list of questions, however, can help you determine if you are making a wise decision.
Read number 2 in the list on the right. In economic terms, what would you call the other item that you must give up buying if you pay cash now for the first item?
The decision to borrow or use credit involves whether the satisfaction the borrower gets from the purchases is greater than the cost of the interest payments. It is basically a question of comparing costs and benefits. The benefit of borrowing is being able to buy and enjoy the good or service now rather than later. The cost is whatever the borrower must pay in interest or lost opportunities to buy other items or earn interest on the amount put into a savings account or investment.
The benefit of borrowing is something only you can decide. You and every other borrower, however, should be aware of the costs involved. Figure 4.3 can help you decide when to use credit. It can also help you avoid the improper use of credit by overspending.
Suppose you want to buy a pickup truck that costs $15,000. You have a choice. You could borrow $15,000 right now and buy the truck, but you would have to make interest payments on the borrowed funds for three to five years. You can also enjoy using it, though, at the same time you are paying for it. Alternatively, you could start saving now, earn interest on your savings, and pay cash for the truck in several years.
- credit: receipt of funds either directly or indirectly to buy goods and services in the present with the promise to · pay for them in the future
- principal: amount originally borrowed in a loan
- interest: amount the borrower must pay for the use of someone else’s funds
- installment debt: type of loan repaid with equal payments, or installments, over a specific period of time
- durable goods: manufactured items that have a life span longer than three years
- mortgage:installment debt owed on houses, buildings, or land