While credit can seem complicated and difficult, if handled wisely, it’s simply a tool that you can use to reach your goals. It can offer convenience, some consumer protections, the ability to purchase a home or education, and may even have certain rewards. It can, however, be expensive and many consumers struggle with excessive debt because of credit mismanagement or a financial crisis.
Types of Credit
Credit falls into four major categories: closed-end vs. open-end and secured vs. unsecured.
Closed-end debt includes personal loans, student loans, most mortgages, and car loans. You borrow a specific amount of money and make regular, consistent monthly payments over an agreed-upon period of time to pay it back.
Open-end debt is also known as revolving credit, like credit cards and lines of credit. You can access the money at will and repay it based on what you borrow.
Unsecured debt is granted based on your promise to repay it. Creditors generally take into account the “4 C’s” of consumer credit when determining whether to grant credit, how much, and at what rate. These include credit (your payment history), capacity (your ability to repay based on your income and other debts), character (a subjective measure of your ability and willingness to repay the debt), and collateral (assets that a lender can possess if a borrower defaults on the loan).
Secured debt is a loan made with an asset, such as a car or a house, as collateral. This collateral secures the loan; if you don’t pay it, the creditor can seize the asset. Because there is less risk to the creditor, most secured loans have a better interest rate than unsecured loans.
Common Credit Terms
- Annual percentage rate (APR) is the annual rate of interest, which may be fixed or variable, charged on the outstanding balance on your debt. A different APR may be charged for different transactions. For example, for credit cards, the APR for cash advances is usually higher than the APR for purchases.
- A credit limit is the maximum amount that you can borrow on a given account. Knowing your credit limit can help you avoid over-limit fees.
- Over-limit fees are charged by the creditor if your revolving debt exceeds your credit limit. While credit card issuers may not allow purchases over the limit without express permission, late fees and missed payments can push you over the line.
- Late fees are charged if your loan or credit card payment isn't received by the due date.
- A grace period is the amount of time before interest is assessed on new purchases—typically 21-30 days from the last day of the billing cycle. (There is usually no grace period for cash advances.)
- Annual fees are charged for the privilege of using a credit card. It’s usually between $35 and $100. If you have good credit, you can likely switch to a card that does’t charge this fee.
- Joint accounts are accounts you share with another person, usually a spouse, as opposed to individual accounts. Joint credit is granted based on both of your credit and financial information. You are both responsible for paying it and the account will be reflected on both of your credit reports.
- An authorized user is a person who is approved by a creditor to use an account but is not responsible for paying it.
Credit Cards in the real world
Credit cards offer convenience, consumer protections and a quick way to build good credit, assuming you use them responsibly. Use them unwisely, and your credit can suffer, which affects your ability to borrow money in the future. Understanding how credit cards work will help you choose the right cards for you, manage them well and save money.
When your bill comes, you have the option of paying a certain minimum amount, paying the whole balance in full, or paying some amount in between. Paying just the minimum every month is ultimately the most expensive option, since it will cost you the most in interest. A financial calculator may be useful in order to show how long it would take you to pay off your credit card if you only pay the minimum balance. Paying in full is the best option; when you pay in full each month, you get a grace period that allows you to avoid paying any interest on purchases at all.
Tips for effective credit card use
The benefits of using a credit card responsibly outweigh the costs. Here are some good practices to adopt:
- Pay your bill on time and in full every month
- Keep your balance below 30% of your available credit. For example, if your credit card limit is $1,000 try not to have a balance of over $300.
- Wait at least six months between credit card applications
- Review your account online weekly to track spending and avoid fraud
Using a credit card responsibly is an easy and efficient way to establish healthy credit. You’ll be thankful that you did so when you’re able to borrow affordably in the future.