Part 2: Understanding Credit
Credit is your ability to borrow money. Anytime a bank, finance company, or business lends you money and you agree to pay it back at a later date, you are using credit. In most cases, there is a charge for borrowing the money, either in the form of fees or interest or both. There are both advantages and disadvantages to using credit.
Advantages of using credit:
- Credit allows you to purchase large items that you might not have enough cash to pay for such as a house, car or college education.
- Credit can be a good tool for emergency situations.
- Credit is convenient. Using a credit card is a way to pay for things without having to carry large amounts of cash. Also, your monthly credit card statement provides you with a record of your purchases.
- Some credit card companies may offer protection against your liability in the event that someone uses your card number to make unauthorized purchases.
Disadvantages of using credit:
- Credit costs money. There is usually a charge for spreading payments over a period of time.
- Credit can tempt you to spend more than you can afford to repay. You are more likely to purchase items that you do not need.
- Lenders, employers and landlords often request a copy of your credit report. If you mismanage your credit, get a job, rent an apartment, or buy a house in the future.
- When you make a purchase using credit, you commit to using your future income to repay the loan.
- Lenders will report all missed credit payments to the credit bureaus. This will affect your ability to get additional credit in the future.
- If you mismanage credit and are unable to repay the lender, they may repossess, or take back, the item you purchased.
Credit Affects Your Ability to Borrow Wisely
Your credit is one of the factors that will determine what interest rate you will qualify for with most lenders. In general a higher credit score rating will mean greater access to lower interest rate loans.
Protect Your Interest!
Whether you are shopping for mortgage loans to buy a home or considering refinancing or a home equity loan on your existing home, you need to protect your interest. When shopping for a loan, make sure to find the product with the lowest interest rate and most favorable terms.
Interest Rate Comparison Chart
The following compares loans at different interest rates for a $175,000 loan, with a 30-year Fixed-Interest Rate Mortgage Loan.
A higher credit score rating will help you get the lower interest rate loan and save $515 a month or $185,220 over the life of your loan!
You may not have a credit rating, simply because not enough information is available about you. It is important to meet with a Housing Counselor to see what you should do to establish credit to purchase a home. Here are some general ideas for building a credit history over time:
- Start by opening a checking account and do not overdraw it.
- Make regular deposits into a savings account.
- Once you have a relationship with a bank, you can apply for a checking or savings account line of credit to establish a line of credit. You can deposit money from the line of credit into a savings account while making payments on the line of credit. This way you will build savings at the same time you are establishing credit. Ask your bank about a secured line if credit.
- Make sure your rent, untilities, and other bills are in your name and that you pay them on time each month as it may be possible for a lender to use your bill paying history as alternative credit to help you buy a home.
Credit Cards: What You Need to Know
Studies have shown that people generally keep their first credit card for 15 years. That’s why creditors target young people as potential customers; the relationship lasts so long because younger consumers frequently don’t know how to find better deals.
Some people claim that credit card companies aggressively recruit students in an effort to get them “hooked” on credit by luring them with t-shirts and other freebies when they apply for cards. This course is designed to give you the facts you need to become a wise consumer and the tools you need to use credit wisely.
Don’t let yourself be lured by the offers. A credit card is not an invitation to spend money you don’t have. Let’s say you run up $500 on a credit card that charges 15% interest and requires a 2% minimum payment each month. Even if you never charge another item and pay the minimum on your account, it will take 6 1/2 years to repay your debt. When you have finally paid your debt, you will have paid nearly $300 in interest on your $500 purchase, making your total cost $800.
You’ll pay even more if you make late payments or go over your credit limit. Always pay on time, even if you just pay the minimum due. Late fees have skyrocketed; it’s not uncommon to find a $30 late charge applied to your account for a payment that’s only one day late. Credit card issuers also may increase your interest rate if you’re 60 days overdue.
Your credit report affects more than you ability to get a credit card or a loan; it can also affect your ability to get a job or get into college. Many employers and colleges review credit reports to judge an applicant’s character. Late payments, over-the-limit charges and heavy debt can affect you adversely. Hopefully, the tools you gain from this course will help you avoid future credit problems.
Pros & Cons of Using Credit
- Able to buy needed items now
- Reduce a need to carry cash
- Creates a record of purchases
- More convenient than writing checks
- Consolidate bills into one payment
- Interest (higher cost of items)
- May require additional fees
- Financial difficulties may arise if one loses track of how much has been spent each month
- Increased impulse buying
Types & Sources of Credit
This is when items and services paid for in one payment, within a stated time period. Interest is usually not charged. Examples:
- Utility companies
- Medical services
- Some retail businesses
This is when merchandise and services are paid for in two or more regularly scheduled payments of a set amount. The interest is included. Money may also be loaned for a special purpose, with the consumer agreeing to repay the debt in two or more regularly scheduled payments. Examples:
- Some retail businesses, such as car and appliance dealers
- Commercial banks
- Consumer finance companies
- Savings and loans
- Credit unions
Many goods and services can be bought using revolving credit as long as the total amount does not go over the consumer credit limit. Repayment is made at regular time intervals for any amount at or above the minimum required amount. Interest is charged on the remaining balance. Examples:
- Retail stores
- Gas stations
- Financial institutions that issue credit cards
How Much Credit Can You Afford
Never borrow more than 15% of your yearly income.
If you earn $500 a month after taxes, your yearly net income is 12 x $500=$6,000
Calculate 15% of your annual net income to find your debt load. $6,000 x 15% = $900
So, you should never have more than $900 of debt outstanding.
Note: Housing debt (mortgage payments) should not be counted as part of the 15%.
Monthly payments shouldn’t exceed 10% of your monthly net income.
If your take home pay is $500 a month: $500 x 10% = $50.
Your total monthly debt payments shouldn’t total more than $50 per month.
Comparing Credit Cards
Cost of Credit:
- Know the penalties for missed payments.
- Annual Percentage Rate (APR); interest rates can vary greatly.
One card issuer could offer you a 5.99% rate while another could offer you a 21% rate. The difference in what items will end up costing can be astounding.
- Annual fees; some cards have no annual fee while others can be up to $75.00.
- Transaction fees; if you do a balance transfer – what will it cost you?
- Grace period; how many days after the due date do you have to pay your debt before you are assessed a late fee? Most cards no longer have grace periods.
Credit Card Features:
- What’s your credit limit?
- How widely is the card accepted? Think about the advantages of a major credit card versus a store credit card.
- What services are available?
Before You Sign Up for a Card:
- Shop around for the best terms. Bankrate.com is a great resource for finding the best available deals.
- Read and understand the contract.
- Don’t rush into signing anything.
- Once a contract is signed, keep a copy of it.
- Know what the penalties are if you miss a payment.
- Figure out total price when paying with credit.
- Make the largest possible monthly payments.