How Credit Works

Your choices define who you are—especially when it comes to how you spend money. Major decisions become part of your financial history, which can have a big impact on your future.

Credit is a financial tool you'll need frequently over the course of your life. Misusing it can be devastating. Understanding how it works can help you build a solid history that will open doors and advance your goals.

Whenever someone loans you money, they extend credit to you. Usually it's a financial institution, which lends you money (or principal) in exchange for your promise to pay it back with interest. Credit can come in many different forms, including loans (for homes, cars, furniture or other items), credit cards, and lines of credit.

Interest is the amount you pay to use someone else's money. Banks typically charge a percentage of the principal you borrow—that percentage is known as the interest rate. The higher the interest rate, the more it costs to use credit.

When you sign a loan application and accept a loan, you and the lender both agree to certain terms and conditions. For example, lenders are responsible for being truthful in their advertisements and for telling you in writing how much you'll pay to use their credit. You're responsible for paying back the loan according to the terms of your agreement. If you fail to hold up your end of the bargain, the lender may take legal action against you through collections, judgments, or liens.

• Credit score: A score calculated by a credit-reporting agency based on a consumer's history in obtaining and repaying various types of credit.
• Collateral: Any titled vehicle (auto, motorcycle, boat) that is used for a loan. The credit union or bank would hold the title to that vehicle until the loan is paid in full.
• Collections: Efforts by a financial institution to collect on a delinquent debt. Sometimes the loan will be turned over to a collections agency. These actions are reported to credit reporting agencies and will affect your future credit score.
• Debt ratio: The amount of payments you have in relation to your income.
• Judgment: When a judge or court rules against you for an unpaid debt. This information will appear on your credit report, and your wages may be garnished to satisfy the loan.
• Lien: When a judgment is made against you, the lender may secure a lien against any real estate or property you own to ensure the outstanding loan amount is paid upon the sale of the property—before you can use the money for any other purpose.
• Loan to value: The loan amount compared to the value of the collateral.
• Revolving account: Another term for a credit card or line of credit when there is no fixed loan term. Payments for these loans are generally a percentage of the total loan balance for the previous month.

You've probably guessed by now that using credit isn't free. In fact, you'll have to pay for the privilege. Costs of using credit include:

• Annual percentage rate: The annual percentage rate (APR) is the most common way interest rates are quoted and advertised. It's the amount you spend each year to use credit, expressed as a percentage rate. The APR helps borrowers compare the actual cost of obtaining credit because it includes the interest rate as well as other charges like any applicable loan fees, transaction fees, and service charges. For instance, an APR of 9 costs you less than 9.25 percent.
• Application fee: Banks and finance companies commonly charge this fee to process a loan request, regardless of whether the loan is approved. Application fees are often collected with the loan application.
• Annual fee: This yearly charge for the privilege of using credit, usually associated with credit cards, is often automatically added onto the existing loan or credit card balance when it becomes due.
• Finance charge: The actual dollar cost of obtaining credit over the term of the loan, expressed as a dollar amount. The finance charge includes interest plus other loan costs, such as the fees discussed above.
• Origination fee: Sometimes the lender charges an extra fee, usually on home loans, when the loan is set up and disbursed to the borrower.
• Loan term or repayment period: The repayment period is the amount of time it will take to pay off the loan. While a longer repayment period may mean a lower monthly payment, you could end up paying more finance charges over the life of the loan because you're borrowing the money for a longer period of time.

Credit comes with a price, but it also offers many benefits. For example:

• It allows you to make large purchases—such as an automobile or a home—and pay them off over time rather than having to pay cash.
• You'll have access to cash in an emergency—for instance, when you need to pay for a tow truck, medical costs, or auto repairs.
• It's safe and convenient. It's often safer to carry a credit card instead of cash when traveling because it's easier to replace if lost or stolen.

The first time a creditor inquires into your credit or you make a transaction that gets reported to a credit bureau, your credit report is established. Because your credit report stays with you all your life, it's important to start out with a positive credit history—and keep it that way. This will help you when you need to take out a loan, rent a home or apartment, purchase a home, or even when you apply for certain jobs. It's basically a report card that reflects your credit history for the past 7 to 10 years.

Items that appear on your credit report include:

• Credit Inquiries—loans you've applied for.
• Loan history—loans that were granted to you (and how much).
• Payment history—how promptly you made your payments, and if any payments were missed.

Your credit score is a calculation based on the data in your credit report. This score helps lenders evaluate the likelihood that you'll pay back your loan. It's based on the following factors:

• Current or past delinquencies and late payments.
• Capacity of credit lines—how much you owe compared to the available credit limit (used for credit lines and credit cards).
• How old your credit history is.
• Accumulation of debt—how many loans you have and how quickly you acquired them.
• Mix of credit between revolving (credit card) and installment (auto loan) accounts.

The higher your credit score, the better your reputation with lenders. In fact, since many lenders base the interest rate of your loan on your credit score, a good credit score is essential to getting the best loan rates possible. You can see how important it is to build and maintain a positive credit score.

Building your credit history takes time. There are several ways to get started:

• Investigate getting a credit card or jewelry store charge account with a small credit limit, and pay off your purchases quickly.
• For your first loan, consider a share-secured loan, which uses the money in your savings account as security.
• Ask someone with well-established credit to co-sign for your loan. A co-signer is fully responsible for the loan; if you default, they'll become a target for collection efforts from the lending institution. Their credit report will also reflect your loan as their obligation even if you're the one making all the payments.

There are many different types of credit, but we're going to focus on the two main types you'll need to know about: collateralized loans and credit cards.

Collateralized Loans

When you borrow money for a car, boat, or motorcycle, generally the loan is collateralized, meaning the item you're purchasing is used to secure the loan. If the loan goes into default, the lender reserves the right to repossess the collateral.

With a collateralized loan, you must maintain the condition of the collateral and obtain the necessary insurance in case of an accident so the collateral can be restored to its original condition at the time of purchase.

Vehicle loans have a fixed number of payments over the repayment period, and the interest rate is often fixed for the entire loan term. Here's what a typical auto loan looks like:

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You can see that by borrowing this amount, the cost of the car is increased by about 20 percent. On a loan such as this, you'll also want to check for potential hidden costs. These might include "pre-payment" penalties, or charges that offset the amount of interest you would have paid over the remainder of the loan, so even if you pay it off early you may not save much on finance charges.

Because you're paying off your vehicle over time, choose a vehicle that will remain as dependable as possible during the entire loan term. Shop around, research online, and have your mechanic check out the vehicle to reduce the chances of any expensive surprises.

Credit Cards

A popular way to borrow money is through a credit card or revolving account. In addition to many nationally accepted credit cards, like Visa or MasterCard, consumers can obtain credit lines through their favorite department stores (such as Sears or JC Penney), variety stores (such as Target and Wal-Mart), and gas stations.

Credit cards offer many benefits, including the ability to make a major purchase and pay it off over a period of time. It's also more flexible than a traditional loan because you can make small purchases over time rather than receive your loan amount in a lump sum. In addition, using a credit card while traveling can help you avoid problems with out-of-state checks or not having the correct identification.

This flexibility has a price, however. With so many companies telling us to buy now and pay later, it's easy to make additional purchases before you've paid off your previous purchases. Then, instead of paying off the entire loan amount, you end up making only minimum payments while the balance continues to rise. This is where the earlier lesson about the cost of using credit comes in—the longer it takes you to pay off your loan, the more you pay for the goods or services you've purchased.

Here is an example of what can happen when you only make the minimum payment on your credit card loan:

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Wow—that's a long time to pay off a purchase! When you consider making a credit card purchase, ask yourself this question: "By the time I pay off my balance, will I still be using the item I've purchased?" This can help you resist the temptation to use your credit card for instant gratification.

Not all credit cards are created equal. It's wise to shop around and find a deal that works for you. For example:

• Look carefully at the interest rates and fees.
• Be wary of cards with low introductory rates that shoot up after a given period of time or in the event of a late or missed payment.
• Read the fine print to make sure you're getting the best deal possible.

One Last Caution about Credit Cards

As soon as you receive one credit card, you often open a floodgate for more offers. Having the discipline to keep your credit cards to a minimum, and use them sparingly, is essential to building a successful budget and credit score.

If you charge beyond your means and find yourself with too much debt, here are a few tips:

• Stop using your credit cards; don't create a larger hole to climb out of.
• Even if you can only make small payments above the minimum, concentrate on paying off the highest-interest cards first—not the ones with the largest balances.
• If you're unable to make even minimum payments, seek the advice of a non-profit financial counseling organization like Money Management International. Your bank or credit union should be able to recommend a reputable firm. Don't work with organizations that charge large fees or promise to "correct" your credit score.
• Bankruptcy is never a solution to a spending problem—seek financial counseling or debt management advice before you resort to something as harmful to your credit report as a bankruptcy filing.

Congratulations! You've made it through our "Understanding Credit" financial education course. So far, you've learned:

• What credit is and how it works.
• The costs and responsibilities of using credit.
• The types and sources of credit.
• How your credit score is calculated.
• The main questions you should ask before using credit.
• What happens if you misuse credit.

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