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.