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Understanding Credit

Credit in Today's World

In today’s world, it seems that credit is a normal part of life. There are advantages and disadvantages to using credit. It is important to understand credit and its potential pitfalls. When you understand credit, you can decide how, and to what degree you will use it in the future.

Advantages vs. Disadvantages

Advantages:

  • Able to buy needed items now
  • Don't have to carry cash
  • Creates a record of purchases
  • Consolidates bills into one payment

Disadvantages:

  • Interest (you will pay more for the items than they originally cost)
  • May require additonal fees
  • Overspending due to not keeping good records
  • Increased impulse buying may occur

Your Responsibilities

  • Borrow only what you can repay
  • Read and understand the credit contract
  • Pay debts promptly
  • Notify the creditor or bank if you cannot pay your payment on time
  • Never give your credit card number over the phone unless you initiated the call or are certain of the callers identity

Know How Much You Can Afford: The 20-10 Rule

It is best to avoid debt altogether if possible. However, if you do use debt to purchase anything, you should follow the 20-10 rule. The 20-10 rule will limit your debt so that it does not take up too much of your budget.  

20-10 Rule:

Never borrow more than 20% of your yearly net income.

AND,

Never let your debt payments get above 10% of your monthly net income.

The 20-10 Rule Example

Let’s look at an example of the 20-10 rule:

If you earn $2,000 a month after taxes, then your yearly net income is $24,000.

To find the amount of debt that your budget can handle, multiply $24,000 by 20%.

$24,000 x 20% = $4,800 of debt

Note: Debt for your home (your mortgage payment) does not count as part of the 20%. In this example the 20% or $4,800 would include credit card debt, car loans, student loans, and any other type of consumer loan.

Monthly payments should not be more than 10% of your take home pay.

If your monthly take home pay is $2,000, your payments should not be more than $200 a month.

$2,000 x 10% = $200

Note: Again, debt for your home (your mortgage payment) does not count as part of the 10%.  In this example the 10% or $200 would include credit card payments, car payments, student loan payments, and any other type of consumer loan payments. 

Types of Credit

Single Payment Credit

Items and services are paid for in a single payment, within a given period of time, after the purchase. Interest is usually not charged.

For example, utility companies send you a bill after they know how much of their services you used. They do not charge interest.

Also, when you have a service performed now, but agree to pay for it later, it can be referred to as service credit. An example would be if an exterminator comes to your house and sprays for bugs, then sends you a bill later in the week.

Open Ended Credit

Open ended credit can also be referred to as revolving credit.

Credit cards are a type of open ended or revolving credit. Many items can be bought throughout the month as long as you do not charge more than your credit limit.

Repayment is made at the same time every month. Only a small portion for the cost of the items is due monthly. Interest is charged on the balance.

Another example of open ended credit is a line of credit that you could obtain from a bank. This is a loan made on a continuous basis. The bank gives you a limit of how much you can take from the line of credit.

However, the bank does not give you a set payment amount or a certain amount of time to pay the money back. You are typically only required to pay interest.

Closed Ended Credit

Closed Ended credit is also referred to as installment credit because you pay the money back in set "installments".

Merchandise or services are paid for in regularly scheduled payments of a set amount. Interest is included in each payment.

An example is a loan from a bank, credit union, car dealership, or appliance dealer. 

Secured Loans

All loans, no matter what type they are, are either secured or unsecured.

Secured Loans are secured against an asset you own, such as your home or car. If the loan is secured by your car, your car is referred to as collateral or something pledged as security for repayment of a loan.

If you do not pay the loan payments, the bank will repossess your car, which is when they retake possession of something because a buyer does not pay the loan. Secured loans typically have low interest rates since the bank can get their money back by taking the collateral and selling it if they need to.

Mortgage

The most common type of secured loan is a mortgage. A mortgage is a loan that is secured by your home.

If you do not pay your mortgage, the bank or mortgage company will foreclose on your home which means taking possession of a your property as a result of failure to pay the loan.

Unsecured Loans

Unsecured loans are loans that have no collateral. They are also referred to as "signature loans" since you can get an unsecured loan by signing your name and promising to repay it.

Since these loans are much riskier for the bank, they typically have a higher interest rate.

An example of an unsecured loan is a student loan.

Fixed Rate vs. Variable Rate

  • A fixed rate loan is a loan that has the same interest rate for the entire life of the loan
  • A variable rate loan is a loan that can have a fluctuating interest rate. That means that your payment can go up if the interest rate goes up. Most people do not prefeer to take the risk that their payment could go up

Low Interest vs. High Interest

Loans are often necessary in life. Remember that:

  • Low interest rate loans can allow you to continue investing your discretionary income, leading to wealth accumulation.
  • Discretionary income is the amount of income that a household or individual has to invest, save or spend after taxes and necessities are paid (Nickolas 2019).
  • High interest rate loans have a high opportunity cost toward wealth accumulation. You will not be able to invest your money for growth if you are paying a higher rate.

Whatever type of loan you acquire, be sure there is no penalty for early payment.

Credit Cards

About Credit Cards

When you are issued a credit card, you are given a maximum balance. The maximum balance is also referred to as your credit limit. You can charge as much or as little as you wish, as long as to stay below the credit limit.

Credit cards are unsecured loans, so the interest rates are high. Since you only have to pay a small amount every month, it can be tempting to charge a lot on your card and pay it off over time. However, if you do this, you will end up paying a lot of interest and give up the opportunity to invest your money wisely.

Important Terms

If you do decide to use a credit card, it is important to understand the terms of a credit card. The terms of a credit card can make a huge difference in how much you pay for the use of the credit card.

As always, it is wise to shop around because it can save you money in the long run.

Credit Card Terms

Let's look at some of the terms that you will need to know if you wish to use a credit card.

  • Annual Fee - flat, yearly charge for use of the credit card.
  • Annual Percentage Rate (APR) - measure of the cost of credit expressed as a yearly rate. The Truth-In-Lending law requires lenders to include all loan costs in the APR. As a result, you can compare the APR of different lenders to find the best deal.
  • Cash-advance Fee - fee charged when you get cash using your credit card (this is in addition to the interest charged). The grace period does not apply for cash advances.
  • Finance Charge - dollar amount you pay to use credit.
  • Free (Grace) Period - period of time (usually between 20 and 30 days) during which you can pay your bill without incurring a finance charge. You MUST pay your bill in full in order to take advantage of the grace period.
  • Interest Rate - measure of the cost of credit, expressed as a percent.
  • Late Fee and Transaction Fee - a credit card also may involve other types of costs. For example, if you go over your limit or make your payment late, you are likely to be charged a fee. If the company receives your payment late, you are likely to be charged a fee. If the company receives your payment after grace period, you may be charged both a finance charge and a late-payment charge. Some cards also may charge a penalty rate if you have more than one late payment within several months.

Citation

Unless otherwise noted, all images featured in this presentation are original works created by ACCESS, available by public domain, or licensed from iStock or Articulate.

Nickolas, Steven. "How Do Disposable Income and Discretionary Income Differ?" Investopedia, Investopedia, 12 Mar. 2019, www.investopedia.com/ask/answers/033015/what-difference-between-disposable-income-and-discretionary-income.asp.