Using Credit Wisely

Learning Goals Once you have completed this module, you will understand: What credit is. Some tips on how to use credit wisely. The difference between open-end and closed-end credit. What a debit card is. What you can do to improve your credit.

1. Introduction

Now that you have established a spending plan and have learned about ways to adhere to your plan, it is important to learn about credit and how your credit history can affect you. This module will explain which types of credit are available, provide some tips on how to use credit wisely, and explain why it is important to establish a good credit history.

2. What is Credit?

Credit is your ability to borrow. When you have good credit, you are able to borrow cheaply. If you have very poor credit, if you are even able to borrow, it is very expensive. It is important to have good credit so that it isn't very expensive to borrow.

Types of Credit

Credit comes in many different forms. In each, you owe money to someone. The following are several forms of credit:

• Unpaid bills (rent, medical, utilities, etc.)
• Credit cards
• Mortgages
• Personal loans
• Business loans that you are reponsible for

With each of these forms of credit, you should be aware of several characteristics. First, the interest rate. This is the rate that you are charged to borrow. Usually you are not charged interest for the credit you receive for unpaid bills, although you are required to pay those bills back quickly (within 30 days or less), or you may be charged penalties. Mortgages carry interest, and rates vary, but current market rates are around 6%. Credit cards have the highest interest rates, from 11 to 23%.

Second, you should be aware of whether you are repaying principal. You are repaying principal when you pay down the amount you owe. You repay all the principal each month when you pay your regular rent and utility bills. With a standard mortgage, each payment you make includes a partial payment of principal, and partial payment of interest. If you are not repaying principal, you are only paying interest, and you are not making progress toward getting out of debt. And, if you are not paying interest, then your debt is growing.

Third, you should be aware of fees associated with your debt. For many debts, you will owe a late penalty if you pay late. For others, you are charged fees to make the initial borrowing (e.g., points on a mortgage, closing fees for a personal loan). Fees can add up to thousands of dollars if you are not careful.

Finally, some borrowing puts your house at risk. With a mortgage, if you do not pay, the lender can foreclose and ultimately you can lose your house. The same is true with a home equity line of credit. Credit cards are "unsecured," which means that a credit card company cannot force you out of your house without first going to court and suing you for payment.

Open-End Credit vs. Closed-End Credit

Generally speaking, there are two types of credit: open-end and closed-end. With open-end credit, the borrower spends however much money he or she would like to spend up to a pre-set limit, and then pays back the loan by making periodic payments. Most credit cards are open-end in that the credit card holder can use the card to spend as much money as he or she would like to spend each month (up to the pre-established limit), and then pay back the money (or a portion of the loan) each month.

With open-end credit, the borrower can borrow as much money as he or she would like to borrow up to the pre-set limit. This can be troublesome for some people, as some individuals may have a credit limit that may exceed what they can pay within their monthly budget. If these individuals spend too much each month, they may wind up accumulating a great deal of debt, and may have a difficult time repaying the debt, as credit card interest rates are very high.

With closed-end charges, the company providing the loan determines how much the borrower needs to pay each month and the borrower must pay that amount each month until the loan is paid off. An example of using closed-end credit to make a purchase is when an individual buys a sofa from a furniture store, agrees to pay $200/month for a year, and at the end of the year the sofa is paid off and the borrower owns it “free and clear.”

Debit Cards

Tip: when using a debit card, be careful not to be overdrawn. It can take a few days for a debit to reach your account, and if you are not careful you may be charged overdraw fees which can be large (up to $30 per transaction).A debit card allows the cardholder to pay for purchases by making direct withdrawals from the cardholder’s bank account. With this type of card, the cardholder cannot spend more money than he/she currently has in his/her bank account. Thus, it is impossible to accumulate large amounts of debt by using debit cards instead of credit cards. Individuals who may be tempted to spend more than their budgets allow may want to consider getting rid of all of their credit cards and using debit cards instead.

Credit Cards vs. Debit Cards

Although debit cards allow cardholders to make purchases in much the same way credit cardholders make purchases, credit cards can come in handy for several reasons.

First, they can be useful in case of an emergency situation where the cardholder may need to pay for medical care, transportation, etc. during a crisis. Second, many credit card companies offer rewards to cardholders in the form of frequent flyer miles, cash back, gas credits, or points toward gift purchases based on the amount of money charged each month. Third, some credit cards offer rental car insurance coverage or other types of perks that may be useful in certain situations. If you decide you would like to retain a credit card for one of these reasons, stick to only one card and ask the card company to establish a monthly spending limit that is within your budget.

Unlike credit cards, which have a pre-set monthly limit, but allow the cardholder to spend any amount up to that limit each month, debit cards only allow the cardholder to withdraw an amount up to the amount that is in the cardholder’s bank account. Thus, it can be helpful to use a debit card instead of a credit card if you tend to spend beyond your means with credit cards.

Good Credit Habits

There are several important habits that you should get into when using credit.

First, repay your debts as soon as possible. If you make a habit of repaying your debts as soon as possible, you won't run the risk of having debts spiral out of control when a financial emergency strikes.

Second, don't incur late penalties and fees. Pay your bills on the day that they arrive. Don't put them aside and pay them later. If you delay, you could end up accidentally paying late and then paying a lot more because of fees and penalties. In addition, if you get in the habit of paying late, this could hurt your credit history (discussed more later).

Third, don't borrow unless you really need to. Credit card companies and banks make it very easy for us to borrow. But, that doesn't mean that you should borrow. It takes self-control, but you should only borrow when absolutely necessary, because of the risk that you could end up deep in debt.

Finally, check your credit report. This is discussed more in a later page, but you should check your credit report from time to time to ensure that there are no errors that will make it more expensive for you to borrow.

Summary