MONEY MANAGEMENT 4

Credit Can Enhance Your Life

When used wisely, credit can enhance your life. It can allow you to purchase things like a home, a car, and even finance a college education. However, when you use credit unwisely, your financial life can become stressful and difficult.

Credit is a financial tool that can help you get what you want. Financial tools themselves are neither good nor bad; they are just tools. How you use the tools available to you determines whether they will have a positive or negative affect on your life.

Credit comes in many forms: credit cards, charge cards, car loans, mortgage loans, home equity loans, personal loans, consolidation loans, student loans, and more. When you use credit, it becomes a debt. Anytime you use credit, you are relying on the fact that you will be able to pay the debt back in the future, regardless of what is happening in your life.

To purchase an item on credit means that to get the item now, you are willing to pay extra for it. This extra amount is called interest. The amount of interest you pay will be determined by the rate of interest, how the interest is calculated, and length of time interest is paid. You will also pay additional fees to use some loans and credit cards. The less interest and fewer fees you pay, the more money you have for things you need and want.

Whenever you use credit, you should calculate the true cost of an item, which will include all fees and interest you pay. It is not uncommon for people who make purchases using credit to spend two to three times more than if they were paying cash for the purchase.

The most common types of credit include revolving credit, installment credit, and service credit. Revolving credit allows you to borrow up to a specific dollar amount. The monthly payment may vary as your balance changes. As you repay the credit, you will be able to borrow it again. Credit cards are revolving lines of credit.

Installment credit allows you to borrow a specific amount, for a specific period of time. The monthly payment usually remains the same. When you have repaid the amount, the loan is closed. Car and mortgage loans are considered installment credit.

Service credit allows you to pay for a service at a later date. If you cannot make the payment in the agreed upon time, there is a penalty. Utility companies offer this kind of credit. Most types of loans can be categorized as secured or unsecured. Secured loans are backed by property that has value, also called collateral. An example of a secured loan is a car loan, as the car is security or collateral for the loan. In other words, if you don’t make the loan payments, the lender can take back or repossess the car.

On the other hand, an unsecured loan does not have any property backing the loan. If you, for example, apply for a signature loan at a bank or credit union, this would be considered an unsecured loan. Many credit cards are unsecured; however, not all are. Some credit cards are known as secured credit cards. A secured credit card may be secured by your savings account or by the merchandise you purchase. If you don’t make the payment, the lender can and will take the item you pledged as security. Before you sign any credit card agreement, make sure you read and understand all the fine print.

When you want to borrow money, lenders will look at a number of things before agreeing to grant credit to you. First, lenders want to know if you have the financial ability to repay the loan. This is known as capacity. Second, lenders look for any property you have to back the loan—again, this is called collateral. And third, lenders want to know if you will make your payments and how you have handled other loans in the past. This is called character. Capacity, collateral, and character represent the three C’s of credit.

To understand the role a lender plays in the credit-granting process, you might think about what you would want to know if someone wanted to borrow money from you. You certainly would want to know that they have a job and that they have the ability to pay you back. You would want to know how long they have been at their job and that they would make every effort to pay you back. Knowing whether the potential borrower had repaid their other loans on time and in full would also be important to you. Lenders are no different.

Lenders are in business to lend you money–that’s their job. They have federal and state government regulations, as well as company guidelines they have to follow. Some people think that lenders look for any reason not to give a loan, but this simply is not true. Lenders want to make loans, though they want to make them to people who will repay the loan.

When you want to borrow money from a lender, you need to fill out the application completely and honestly. If you aren’t sure how to answer a question on the application, call the lender and ask for help.

When you meet with a loan officer, be helpful and polite. Answer their questions to the best of your ability. Again, put yourself in the position of the lender—if you were going to lend money to someone, you would expect to be treated politely, honestly, and with respect.

If you are turned down for the loan, ask why. It doesn’t do you any good to get upset with the loan officer. You may be turned down for any number of reasons. Ask the loan officer what actions you could take to qualify for the loan in the future. Just because one lender turns you down for a loan, however, doesn’t mean another lender will do the same. If you are turned down at one financial institution, make an appointment to see a loan officer at another bank or credit union.

The way you handle loans made to you will determine whether you have “good credit.” What exactly does it mean to have good credit? You can achieve good credit by making all of your payments, as agreed, in full monthly payments. If you want good credit, you cannot skip payments or pay less than the full amount due. If you have made financial mistakes in the past, it’s still possible to build good credit by committing to paying all of your bills on time and in full.

Credit cards are useful and often necessary for making hotel reservations, buying something online, and getting the best exchange rate when traveling abroad. They offer the convenience of buying something now and paying for it later, and they give you the security of being able to get a refund for damaged or defective products.

While useful in many ways, credit cards can be very costly to you if you opt to carry a balance from month to month, as the chart on the following page demonstrates.

If you have a credit card with an interest rate of 18% and make the minimum monthly payment (typically 2% of the total balance) on a $2,000 balance, it will take you over 30 years to pay off the card. You will have paid $4,931.15 in interest in addition to the original $2,000 you charged on the card, assuming that you never charge another dollar on the credit card. Most people don’t believe this could possibly be true, but the chart below details how paying the minimum monthly payment will keep you in debt for 30 years.

With a balance of $2000, 18% annual interest and a minimum interest of 2%, it will take over 30 years and you will repay $4931.15 in interest

Whenever possible, pay your bill in full. When that isn’t possible, pay more than the minimum monthly payment. If you were to pay $40 a month, every month, on the same balance of $2,000, (rather than reducing your payment as the balance declines), you would reduce the number of months you pay on this debt from 370 to 94 months, and you would reduce the amount of interest you pay from $4,931.15 to $1,724.47.

Various financial institutions issue credit cards. But no matter where you get your card, you should receive a monthly statement detailing any activity on your credit card. While the format of this information may vary, all statements will show your previous balance, any charges you have made, any fees assessed, the credit limit of your card, payments you have made, any amount past due, the minimum monthly payment due, annual percentage rate on your card, your available credit, and the ending balance.

The fees you pay will vary from card to card, so you should read the disclosures closely before signing any agreements. These fees can include a combination of the following:

• Interest– the percentage of interest charged on your credit card each month.
• Late fees– the fee assessed if your payment arrives at the credit card company after the due date.
• Over limit fee– the monthly fee you will pay if you charge more than your pre-established credit limit.
• Cash Advance fees– fees that apply if you use your credit card for cash advances.
• Annual fees– a fee you may be charged for the privilege of having the card.
• Balance transfer fees– fees you may incur by transferring the balance of one card to another card.
• Program fees– a special fee charged by the credit card company
• Additional cardholder fees– a fee that may apply if you order a credit card for another person, such as a spouse.

Fees on your credit card are not limited to those listed above, but these represent the most common ones you will encounter.

Interest may be calculated on a credit card in four ways. How the interest is calculated makes a difference on how much interest you will pay.

The four ways are: average daily balance excluding new purchases, average daily balance including new purchases, two-cycle average daily balance excluding new purchases, and two- cycle average daily balance including new purchases.

Whether or not you carry a balance on your credit card, you want a card that does not charge you interest on new purchases—you want a card that excludes the new purchases. As a consumer, you also want a card that calculates interest on the average daily balance excluding new purchases. The most expensive form of calculation for consumers is the card that is based on the two-cycle average daily balance including new purchases.

The fees on credit cards are constantly changing, so it is important that you read the disclosures your credit card company periodically sends you. Your fees can be changed based on the agreement you have with the financial institution that provides the credit card.

Most credit cards contracts have a clause in them called the Universal Default Clause, a clause that many consumers are unaware of and that can cause them difficulties. The Universal Default Clause states that if you are past due on any of your accounts, with any lender, and it is reflected on your credit report, then your credit card company can increase the interest on your credit card account, even if you have never been late on a payment to that credit card company. In other words, if you make a late payment on any of your accounts, you could end up paying a higher interest rate on all of the cards you hold. The best way to avoid being affected by the Universal Default Clause is to pay your bills on time.

Most people don’t intend to charge a lot of items on their credit cards, but life happens, and before they know it, their balance is higher than they want it to be. They find that they cannot pay off the balance each month. If you find yourself in this situation, the best thing to do is to calculate how much you owe on all your cards and begin paying extra on them. Use the form that follows to take an inventory of all your cards and the balance you owe on each of them.

The average person does not need more than two credit cards, though people often open multiple accounts and fool themselves by spreading the balances owed onto seven or eight cards. You’ll find it is easier to keep track of your debt and get fewer surprises if you have only a couple of cards.

Perhaps one reason that people end up with so many cards is that they get enticed by special “teaser” interest rates that many credit card companies offer. These companies offer 0% interest for the first few months you have the card and offer to transfer your existing balance on another card at a low interest rate as well. Some people constantly change credit cards to take advantage of teaser rates, but you only truly realize savings when you are certain that the new card offers better terms than the one you are replacing. Some cards charge an additional fee for transferring the balance from one card to another.

If you receive an offer for a lower interest rate with a different credit card company, make a quick call to your existing company before deciding to make a switch. If you’ve kept your account in good standing by paying your bills on time and in full, your credit card company will usually agree to lower your interest rate to keep you as their customer. But if you’ve missed payments in the past, don’t expect them to adjust to a new, lower rate at your request. If you are in good standing and your company does not agree to the lower interest rate (and the new card has no additional fees), you always have the option of switching to the new card.

Whether you pay your creditors on time and in full can affect your ability to get credit in the future and influences your credit score—a number that potential lenders use to decide whether to grant you credit and at what interest rate. The next chapter explores how your credit score is determined and explains how this number influences the loan rates you will pay.

Chapter Review

• Credit is a tool that helps you get what you want. It is important to manage your credit wisely.
• Credit comes in many forms: credit cards, charge cards, car loans, mortgage loans, home equity loans, personal loans, consolidation loans, student loans, and more. Credit is a loan that lets you buy something now and pay for it later.
• Most credit card contracts have a clause in them called the Universal Default Clause. The Universal Default Clause states that if you are past due on any of your accounts, with any lender, and it is reflected on your credit report, then your credit card company can increase the interest on your credit card account, even if you have never been late on a payment to that credit card company.