What is credit?
Credit means you use money now and pay it back later. The person or bank who gives the money is the lender (creditor). You are the borrower (debtor). The money you borrow is the principal.
Credit is useful. It helps you buy a home, study, or start a shop before you have saved all the money. But every loan is a promise about your future income. So use it only when you can repay.
Common credit products
- Cash loan / personal loan: money for any use, usually a high rate.
- Purchase loan (buy now, pay later, EMI): the shop or bank pays for a thing and you pay in parts.
- Credit card: a limit you can spend again and again. If you pay the full bill within the grace period (often 20–50 days) you pay no interest. If not, the rate is very high.
- Car loan and mortgage (home loan): big, long loans. The car or house is collateral: the lender can take it if you stop paying.
- Education loan and business loan: credit to build skills or a business.
The cost of credit: interest, fees and APR
Interest is the price you pay for using borrowed money. It is given as a percent per year: the nominal rate.
Simple yearly interest: Interest = Principal × rate × time. 10,000 at 12% for 1 year → 10,000 × 0.12 × 1 = 1,200.
Lenders often add fees: processing fee, insurance, account fee, late fee. A loan with a low rate but big fees can cost more than a loan with a higher rate and no fees.
So lenders must show the effective annual rate, called APR (annual percentage rate) in many countries. It puts interest and fees into one number. Lower APR = cheaper loan. The best check of all is the total amount you repay.
Repaying a loan: instalments and EMI
Most loans are paid back in instalments. Two common ways:
- Equal payments (annuity, EMI): the same amount every month. At first most of it is interest; later most of it is principal.
- Equal principal: the principal part is the same each month and interest is on what is left, so payments start high and get smaller. Total interest is a little lower.
EMI formula (monthly rate r = yearly rate ÷ 12, n = number of months): EMI = P × r ÷ (1 − (1 + r)−n).
Early repayment saves interest, but check if there is an early-repayment fee. Default means you stop paying. Then you pay late fees and penalty interest, the lender may take the collateral or go to court, and your credit history is damaged for years.
Credit score, credit history and choosing an offer
Creditworthiness means: can and will this person repay? Lenders look at your income, your other debts and your credit history (a record of all your past loans and payments kept by a credit bureau). From it they compute a credit score. In India a common score runs from 300 to 900; other countries use other ranges, but the idea is the same.
What helps: paying every bill on time, using only a small part of your card limit, keeping old accounts in order. What hurts: missed payments, default, many loan applications at once.
How to choose an offer
- Read the short information sheet (sometimes called a credit passport or key facts statement): rate, APR, fees, total to repay.
- Compare the APR and total cost of at least two offers.
- Check that the monthly payment fits your budget.
- Read the credit agreement before signing: penalties, early repayment, collateral, insurance.
Borrower duties: give true information, pay on time, tell the lender early if you have trouble, and keep all papers.
Debt traps and responsible use of credit
A debt trap starts when you take a new loan to pay an old one. Interest piles up and the debt keeps growing. Warning signs: paying only the minimum on a card, using one card to pay another, payments taking more than about a third of your income.
Rules for safe credit:
- Borrow for things that last or earn (education, a home, tools), not for daily spending.
- Keep total loan payments well under a third of take-home income.
- Keep an emergency fund so a small shock does not push you into debt.
- If you are in trouble, talk to the lender early or a free debt-advice service. Avoid illegal moneylenders and instant loan apps that hide their rates.
Try it: the 3D and at home
In the 3D (last step): set 10,000, 12% and 12 months. Now change only the months to 36. The monthly payment falls, but the red interest part of the stack grows. Predict first, then check.
At home: find a real loan or EMI advert (newspaper or website). Write down the rate, fees and number of months. Use the EMI formula or the 3D to work out the total you would repay. Is the 'no-cost' or 'low rate' claim true?
Key formulas and definitions
- Simple interest I = P × R × T (R as a decimal per year, T in years)
- Total repaid = principal + interest + fees
- Cost of credit = total repaid − principal
- Monthly rate r = yearly rate ÷ 12
- EMI = P × r ÷ (1 − (1 + r)^(−n))
- Payment-to-income ratio = monthly loan payments ÷ monthly income (keep it low, under about 1/3)
Worked examples
1. Ravi borrows 20,000 at 9% simple interest per year for 2 years. How much interest does he pay?
I = P × R × T = 20,000 × 0.09 × 2 = 3,600. He repays 23,600.
2. Offer A: 10,000 for 1 year at 10% with a 1,500 fee. Offer B: 10,000 for 1 year at 13% with no fee. Which is cheaper?
A: interest 1,000 + fee 1,500 = 2,500 → repay 12,500. B: interest 1,300 → repay 11,300. B is cheaper by 1,200, even though its rate looks higher.
3. Find the EMI for 10,000 at 12% a year for 12 months.
r = 12 ÷ 12 = 1% = 0.01 per month. (1.01)^(−12) ≈ 0.8874. EMI = 10,000 × 0.01 ÷ (1 − 0.8874) = 100 ÷ 0.1126 ≈ 888. Total repaid ≈ 888 × 12 = 10,656; cost of credit ≈ 656.
4. A credit card bill of 8,000 is due. Meera pays only the minimum of 400. The card charges 3% per month on the unpaid part. What interest is added next month?
Unpaid = 8,000 − 400 = 7,600. Interest = 7,600 × 0.03 = 228 in one month. That is about 36% a year, so paying only the minimum is very costly.
5. Sam earns 40,000 a month. He pays 9,000 on a car loan and wants a phone loan of 6,000 a month. Is that safe?
Total payments = 15,000. Ratio = 15,000 ÷ 40,000 = 37.5%, which is more than one third. It is risky; he should wait or choose a cheaper phone.
Common mistakes
- Comparing only the monthly payment. A longer loan has a smaller payment but a much bigger total cost.
- Ignoring fees. A 'low rate' loan with big fees can have a higher APR than a loan with a higher rate.
- Thinking a credit card is free money. Interest is free only if you pay the full bill within the grace period.
- Taking a new loan to repay an old one. This is how a debt trap starts.