Credit is a tool that lets you make better use of your income by having access to funds before they are in your actual possession. Using credit you can weight the cost of borrowing against the improvement to one's life.
Imagine a scenario where you wanted a new television, but it would take you a full year to save up for it. You know that you will be able to save up this money in a year, but you want that television now, not in 12 months.
If you have credit you can have the television now for a cost. This cost is called the "cost of borrowing". This cost of borrowing includes all fees, interest, and other expenses related to borrowing.
Lets say the TV costs a total of $750, after tax and recycling fee and delivery costs. You ask the salesman about monthly payments, he does a fast credit check and with luck you are approved. The deal he offers is that you will pay a $25 financing fee up front, then pay $75 a month for 12 months at 29% compounded interest.
Lets look at the "cost of borrowing" here. By using a loan calculator like this one you can determine how much interest you would pay on such a loan. In this case, $750, at $75 a month at 29% interests means you will pay a total of $869.07 in payments. That is a cost of $119.07, plus $25 for the finance fee. That is a cost of borrowing of $144.07.
Financing from a merchant is often one of the more expensive ways to borrow. If you have your own credit card then you do not have to meet the merchants terms, yours are likely better. Lets say you buy the same TV with a credit card that has a 21% interest rate. Once again you pay $75 a month, accept this time you don't pay a finance fee and your interest is 21% instead of 28%. In this case you pay a total of $831.70 making the total cost of borrowing $81.70. This is much better.
But wait, credit cards don't require that you pay a fixed amount, you only need to pay your minimum. The minimum payment on a credit card is often as little as 3% of your total balance. Lets see what happens if you only pay our minimum on our 21% credit card after buying a TV.
When only paying your minimum payment on your credit card you pay a total of $1504.62, making the cost of borrowing $754.62! What happened? The minimum payment pays the interest, but little more. When you make a monthly payment of $22.50, the first $13.13 goes to pay interest and only $9.38 goes to reduce your actual debt. That means in this situation when you pay only the minimum you are only getting 41 cents on the dollar. For every dollar extra you pay that month it reduces you debt by 100 cents per dollar. If you only payed the minimum you would be paying for that TV for 115 months, that is just short of 10 years.
Now lets say we can pay $100 every month. Your debt is payed off in 9 months and you pay a total of $61.10 in interest.
What I am trying to get across is that you save a lot of money by paying an amount significantly greater than your minimum payment. Remember, more than half of your minimum payment goes to that months interest. You will be charged interest again the next month. Once your minimum is payed every dollar you pay further that month reduces your debt by a full dollar.
