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How Credit Works

Reviewed Jul 25, 2012

Summary

Learn more about:

  • interest
  • credit
  • cash advances

It’s easy, probably too easy, to get credit. You may be getting credit-card offers in the mail. You can get loans to tide you over until your next check arrives. Even if you have nothing saved and barely get enough money to meet your basic costs, there always seem to be ways you can borrow.

If you don’t know better, you’d think this money was free. It’s not, of course. And knowing how credit works can keep you from making very costly mistakes.

First and foremost, you need to remember that lending is business. People intend to make a profit when you borrow from them. That’s not a bad thing in itself. But it tells you that loans are almost never completely free.

The most obvious cost is interest. This is an amount charged to you based on a percentage of the amount you owe. To figure out your monthly interest charge, divide the annual rate by 12 and multiply your balance by that. If you have a balance of $500 on a credit card and 15 percent interest, your monthly interest charge alone would be $6.25, or $75 a year.

Some credit, such as auto loans and home loans, is amortized. Payments include both principal (the amount borrowed) and interest. As the principal is paid down, the interest payments fall. But the total payment remains the same, so each month you're paying a little more principal and a little less interest.

But interest is not the only cost of credit. Credit cards can charge annual fees, whether or not you use them. Also, stores that take credit cards pay the card companies (such as Visa) fees. These usually are included in prices of items you buy. But merchants have the right (under a federal law passed in 2010) to give you a discount if you pay in cash.

What about those “zero interest” credit cards or “no payments for 6 months” installment plans for appliances and other big-ticket items? Both can be free, but only up to a point. For the credit cards, the zero interest rate is almost always just for a short time. After that, the usual high credit card rates kick in. Also, “zero interest” cards can still carry an annual fee. And “nullifiers” can force you to pay interest if you violate certain terms in the fine print.

It goes without saying that you should always read the fine print. Even if you have to buy a pair of reading glasses.

As for the “no payment” plans, you really can get a free loan for 6 months, but you need to pay the principal in full before then. If you don’t, you can be charged interest at a high rate on the unpaid balance. That’s not all. The interest will be charged from the date of your purchase, not from the 6-month deadline. If your purchase was $2,000 and you have $1,000 left to pay at the deadline, you owe 6 months of interest on the $1,000. At 20 percent, that’s $100.

Again, read the fine print. If you don’t understand it, have a trusted friend, counselor or family member go over it with you.

As you already may have noticed, there is a smart way to use credit: Only charge as much as you can pay off each month. Credit cards offer a “grace period,” which means that no interest is charged on purchases paid off at the next due date. But there’s an important exception. Interest usually is charged from day one on cash advances. You may get “checks” in the mail now and then from your credit card company. These are for cash advances. Each time you write one, you’re taking out a loan with no grace period, usually at a high interest rate.

What is a credit score and why is it so important? The score is a rating of your credit record that lenders use to decide if you are a good risk. A high score means you’ve been careful to pay your debts, so you’re likely to pay them back on time. A low score means just the opposite. If you have a low score, you won’t be able to get loans at the best interest rates if you want to buy a car or a house. You may not get a loan at all.

To earn high scores, you need to have some credit history. So you should not avoid credit cards entirely. But you then have to be smart about using the cards. Pay off the balance each month. DO NOT pay just the “minimum payment” on your bill.

And what about other types of credit you may see around you, like “payday loans?” Beware of these, because they can have very high rates of interest. If you need to borrow to make it to you next benefit check or pay check, a loan won’t solve your problem. You have a more basic issue—spending more than your income. You need to deal with that first. 

Resources

The U.S. Federal Trade Commission has a wealth of information on credit and loans at http://www.ftc.gov/bcp/menus/consumer/credit/loans.shtm. Be sure to read the brochure “Getting Credit” at http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre32.pdf.

For information in the new rules on deferred-interest installment plans, see http://www.foxbusiness.com/personal-finance/2010/02/16/payments-anymore/.

For a free (once-a-year) look at your credit scores from the three rating agencies, go to https://www.annualcreditreport.com/cra/index.jsp.

By Tom Gray

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