The Cost of Credit and Responsible Use
WHAT IS CREDIT?
Credit is defines as confidence in a borrower's ability and intention to pay. Normally in the form of loans, credit can come from banks, businesses and individuals. These loans can be used to buy goods and services. Credit usually determines how much you can borrow and how long at a specified interest rate.
You borrow money and make a promise to pay back the principal plus interest. The added interest is the cost of borrowing the money. Making your loan payments on time will give you “good credit” Not only will you be able to borrow more money in the future, the cost for you to borrow will be cheaper.
WHY IS CREDIT IMPORTANT?
- It can be useful for emergencies.
- It is easier than transporting large sums of cash
- It allows for large purchases and the ability to make payments over time
- It determines how much lenders will charge you in interest
- It can affect your ability to obtain employment, since some states allow employers to run your credit
TYPES OF LOANS
Consumer installment loan - is repaid over time with a set number of scheduled payments and used to pay for personal expenses. Examples are:
- Auto loans - The automobile you are purchasing is used as collateral for the loan.
- Unsecured loans - for short-term needs, such as buying a computer.
- Home loans - always secured by your home, there are three types:
- Home purchase loans - for the purpose of buying a home
- Home refinancing - a new and sometimes cheaper loan is replaced with the old loan
- Home equity loans – the borrower uses equity in their home as collateral for the new loan. The amount of equity is the property value minus the debt.
Credit cards – is a line of credit for which you borrow money for payment to a merchant for personal and/or business expenses.
If you do not have money to pay for your purchases, you most likely will not have the money to pay your credit card bill at the end of each month. The Federal Trade Commission has a good article regarding using a credit card for consumers.
COST OF CREDIT
When you get a loan they usually do not require any money up front but that does not mean there aren't any costs. These costs generally are fees and interest.
Fees are charged by banks and institutions for activities such as account maintenance and periodic and/or one-time charges.
Examples of fees include:
- Late or overdraft fees
- Maintenance fees
- Service charges
Interest is compensation to the owner for letting you borrow their money.
The rate of interest can be either variable or fixed:
- Variable rate is when the interest rate on your outstanding balance changes with the market interest rates
- Fixed rate is when the interest rate stays the same for the term of the loan no matter what market interest rates do
Truth in lending disclosures
Credit terms can be confusing since lenders have their own policies and fees.
The Trust in Lending Act (TILA) was passed in 1968 and requires lenders to disclose all charges in an easy to understand manner so consumers can compare the real cost of borrowing.
Lenders must disclose the:
- Principal amount financed
- Annual Percentage Rate (APR)
- Finance charges; fees and interest
- Total number payments with repayment schedule
- Good faith estimate (GFE) of any loan changes
Responsible use of credit
Credit is extended by lenders who believe that you will repay the debt. It can be very useful but it you are not careful, it can cause you serious problems. If everyone decided not to pay their debt at the same time, the entire system defaults and loses. You should never use credit to purchase anything you are not sure of or will not be able to pay for in the future.
Borrowing is justified for large purchases such as cars, homes, school loans and other items that have a long lasting value beyond the time it takes to pay for them up front. Paying for general living expenses on credit is not advised and can often lead to disaster. Bills will accumulate faster than your ability to pay.
Being responsible with credit also means to “live within your means” but also involves some common sense. You may want to drive a $100,000 sports car but if you don't make enough money, you can't afford it.