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What Does Credit Cost?
So far in our look at the basics of credit, we’ve talked about how credit is essentially money that you borrow from someone else with the obligation to pay it back at some future date. The truth of the matter, though, is that in most cases you’re obligated to pay back more money than you originally borrowed in the first place! This is because of something called interest.
Interest is basically the cost of borrowing money. Most of the time interest is expressed in the form of an interest rate; or a percentage of the money you borrowed. Let’s look at a basic example to see how interest works:
When you borrow $500 from somebody, you are expected to pay that $500 back sometime in the future. This $500 is called the principal of the loan or the original balance. Let’s say that you agree to pay back the entire loan, plus 6% interest, in one year. To figure out how much 6% interest is, grab a calculator and do the math: $500 x .06 (or 6%) = $30. So in this case, you’re agreeing to pay back the lender $500 (the principal) + $30 (the interest) for a total of $530.
In the real world, you usually don’t pay back the entire loan at once; it’s more common to pay it back in portions, or installments, over time, usually once a month. For now, however, all that matters is that you have a basic understanding of what interest is and that you understand that you are expected to pay back more money than you originally borrowed.