Why You Should Care About Credit

What is credit?
Getting credit is when a bank, credit union, or other financial institution, even a local department store, makes you a loan – either when they issue you a credit card or when they give you a check for a certain amount in the form of a loan. When you get a credit card or a loan it means that you’re borrowing money from them with the understanding that you will pay them back:

  • a certain amount — either part of, or the entire amount,
  • at a certain time — when your payment is due, typically on a monthly basis,
  • at a certain cost — how much interest

What does credit cost?
One of the most important things to know about using credit is that it will cost you money. In addition to the annual fee that most credit cards charge you for using their card, you also need to know about something called interest. When a bank or a department store or a credit union or a car dealership approves you for a credit card or gives you a loan they will charge you a fee, called interest, for borrowing their money. That’s why it’s so important that you not borrow or charge more than you can afford to pay back. And it’s important that you understand the terms of the agreement – how long you have to pay the loan back and how much interest you’ll be charged on the loan.

Here’s how interest works. Say you have a credit card. If you pay your bill in full, every month, you will not be charged any interest. If, however, you pay only a portion of your bill, the credit card company will charge you a percentage of the money you owe for the balance outstanding. For example, say your credit card carries an interest rate, also called the annual percentage rate (APR), of 16%. (You can find the APR for your credit card under the “Terms” section on the back of your monthly bill.) If you owe $1,000 on a credit card charging you 16% APR you’ll end up owing them approximately an additional $160 a year or about $13 in interest every month. You can find the APR on your monthly bill under a section entitled “Finance Charges.” The important thing to remember is that interest compounds. Let’s say that you’ve accumulated $3,500 in credit card debt at 16% APR. If you don’t charge anything else and make $120 in payments every month it will take you 37 months – more than 3 years – to pay your bill off completely. And you would have paid nearly $4,430 – or about $930 in interest.

Let’s look at another example. Let’s say that you’ve signed a car loan to buy a new car from a local dealership. You take out a three-year loan for $18,000 charging 10%. That works out to a monthly repayment of $580. In this case the interest you’ll pay on the loan is fixed – meaning that every month you’ll pay off a certain amount of the original $18,000 you borrowed plus a certain amount of interest. At the end of three years, you will have paid nearly $2900 in interest. In other words, you will have paid the bank nearly $2,900 for borrowing their money for three years.

Understanding what credit is and how much it can possibly cost you is important.

So why is it important to have good credit?
Managing your credit is extremely important to your financial future. Having good credit means that you have a history of paying back your debts and paying off your bills in a timely manner. It shows banks, stores, and other institutions that you’re responsible with money — that you are willing and able to pay your bills and pay off your debts. Your history of paying your bills on time and paying your debt off is compiled into something called a credit report. Think of it as a report card on your credit habit. Every time you accept a credit card offer, take on a student loan, or sign up for a utility like electrical or phone services, those accounts are recorded by the three major credit reporting companies: TransUnion, Equifax, and Experian.

Your credit habits – good and bad — are then reported by the credit card companies, utilities, etc. to these three companies. So if you regularly pay your credit card bills on time or if you default on your student loan or if you pay the minimum amount of your credit card every month, all of that is recorded by the credit reporting companies. Even things like how often you move, change jobs, whether or not you own a home are all tracked on your credit report.

Why is that important to know? Because when you go to apply for a loan, such as a car loan or home mortgage, the bank or the car dealership will get a copy of your credit report and use it as part of how they decide whether or not to approve you for a loan. Employers and insurance companies can also access and use your credit report as a way of determining whether or not to hire you or to approve you for an insurance policy.

The dangers of accumulating a lot of credit debt
Tania and Juan got married when they were 23. They always intended to be wise with their money but let their credit card spending get out of control quickly. At first they were just charging large items like furniture for their apartment, but then they started using their credit cards for smaller, everyday purchases like dinners out, groceries, dry cleaning, and renting movies. Add in unexpected bills like car repair or doctors’ bills and pretty soon instead of paying their bills off in full, they could only pay only a portion, or even sometimes just the minimum amount due. Using their credit cards became a habit. They started charging things without realizing that by charging them instead of paying cash they were accumulating a lot of debt. They didn’t think about how much it was costing them in interest payments to charge things that they should have been paying cash for.

After a few years they wanted to buy a home. They sat down to figure out how much savings they had and how much debt they were carrying. They were shocked to realize that they owed over $11,500 just in credit card debt. At an interest rate of 16% if they pay off just $100 a month it would take them 115 months – that’s 9 1/2 years! – to pay their card off completely. And they would be charged $7,781.67 in interest to pay a total of $19,281.67!

According to www.cardweb.com, Americans carry, on average, $5,800 in monthly credit card debt. To pay that off by making only the minimum monthly payment, it would take 30 years to pay off. And that amount would include having to pay an additional $15,000 in interest.

Tania and Juan are among thousands of Americans who have discovered the three main dangers of accumulating a lot of debt:

  1. Accumulating debt affects your ability to qualify for future loans or your future buying power. If you carry a lot of debt or you’re unable to pay back existing debt it will show up on your credit report. If you have poor credit (i.e. a history or late payments, failing to pay back a loan) it takes 7 years before it will be cleared from your record. Filing bankruptcy will stay on your record for 10 years. Why should you care about a poor credit report? Banks, lenders, car dealerships and other financial institutions use those reports to determine whether or not they’ll loan you money. A negative report affects your ability to get approved for a future loan to buy a car, a home, etc.
  2. Accumulating debt can compound beyond your control. Credit cards carry interest rates. Interest, or the money you owe on your debt, compounds, or multiplies. Interest compounds quickly. Without realizing it, you can find yourself with debt that has grown out of your control.
  3. Accumulating debt drains your ability to save and invest for your future.Every dollar that you owe toward debt is a dollar that you’re not able to save and invest. The sooner you’re able to begin saving and investing the more money you’ll make toward your financial goals such as homeownership or retirement.

NOTE: Remember that when you co-sign a loan or for a credit card for a family member it means that you’re responsible for paying that debt if he/she doesn’t. The bank will expect you to pay off their debt. If you have gotten divorced, or are in the process of divorce, you’ll want to make sure that you and your spouse have clearly separated your financial responsibilities, or you can be held responsible for your spouse’s debt.

How to establish good credit
Used wisely, credit cards can help you establish a good credit history, which can help you down the line if you want to apply for a loan. If you have credit cards:

  • Pay your bills on time;
  • Pay your bills in full or at least pay more than the minimum amount due; and
  • Reduce the number of credit cards or accounts you have open…in other words, pay off a few of those cards, cut them up and then send a note to the company that you want to close the account. It’s not a bad idea to send a copy of the letter to the three major credit bureaus so they know you’ve closed the account.

Getting a credit card for the first time
You probably get a credit card offer in the mail almost every day. Be careful before signing up. You need to read the fine print carefully. Remember that what you’re signing is a legally binding agreement between you and the credit company. You’re agreeing to pay back the company on their terms. So you need to know what the terms are! Here are some things to look for:

  • The interest rate. Some will offer in big letters on the envelope an outrageously low interest rate. Often that’s called a “teaser”, introductory, or promotional rate. This is a very low rate of interest that only lasts for a short period of time (like 30 to 90 days) and then it’s jacked up to a much higher interest rate of 15, 18, 21% or more. If you don’t look at your bill carefully you may not notice the jump in interest charged until your debt has accumulated substantially. Cards can also carry different interest rates for purchases and cash advances.
  • Fees. Credit cards can charge annual fees, cash advance fees, and late fees: (1) Annual fees. This is a fee charged for just having the card. Some cards charge no annual fee. Others can charge $35, $50 even $100 just for the privilege of using the card. These fees are automatically added in to your monthly bill so you may not notice if you’re not looking carefully. (2) Cash advance fee. The fee charged for withdrawing money from a bank or ATM charged to your credit card. You are typically given a cash advance limit less than your total credit limit and may be charged a higher interest rate, in addition to a fee, for using the cash advance privilege. (3) Late fee. If you are late, or delinquent, in making your payment, you will be charged a fee and your APR may also be raised.
  • Credit and Cash Advance Limit. How much is the maximum you’re allowed to charge, or borrow, using the card? How much cash are you allowed to withdraw using the card?

Many credit cards will now offer additional benefits such as online access where you can check your account on the Internet, free gifts when you open an account, and perks like earning frequent flyer miles or offers for services like insurance policies.

There are several ways to find a credit card – through your local bank or credit union; online; or through a mail offer. Depending on whether or not you have used credit in the past you will be offered a secured or unsecured line of credit. A secured credit card means that you’ll need to give the bank or company a deposit of up to a few hundred dollars. If you fail to pay your bill they’ll take money out of the deposit to make the payment. An unsecured credit card means you won’t be required to make a deposit as a guarantee of payment.

Ideally you want a credit card with a low guaranteed interest rate, no deposit required and no annual fee required for using the card. For more information on applying for, and comparing credit card interest rates check out the following websites:

www.creditsourceonline.com
www.consumer-shopping-guide.com
www.bankrate.com/esp
www.cardweb.com

Establishing nontraditional credit
You can build good credit without having to apply for, or get, a credit card. It’s called establishing a nontraditional credit history. There are several ways you can begin establishing a good credit habit:

  • Stay with your current job for a few years.
  • Pay your utility bills, phone bills, and rent on time. Keep records and receipts of the timely payments.
  • Open a checking or savings account through your local bank and maintain a more than minimum balance.
  • Apply for a line of credit through a small local store (such as a local department store, clothing store, appliance store, etc.) and pay your bills in full and on time.

Your Rights as a Credit Consumer
You have rights as a credit consumer! By law, the Equal Credit Opportunity Act (ECOA) prohibits credit discrimination on the basis of sex, race, marital status, religion, national origin, age, or receipt of public assistance. Even if you’re asked for this information, by law creditors can’t use it to deny you a loan. You also cannot be denied a loan or credit card, or charged a higher interest rate simply because, for example, you are a Latino American or a woman. If you are denied a loan you have the right to find out why. Lenders are also prohibited from charging you a higher interest rate on your loan because of your race.

For more information on your rights as a consumer, check out the following link to the Federal Trade Commission’s website:
www.ftc.gov/bcp/conline/pubs/credit/ecoa.htm

Tips for Keeping Your Credit Habits Under Control

  • Try to have only 1 or 2 major credit cards
  • Unless you’re trying to establish credit for the first time, don’t get cards for individual store accounts.
  • Shop around for the best, lowest-cost credit card. By doing some online research you can find cards that offer low interest rates, no annual fees, and benefits such as insurance, frequent flyer programs and more. If you’ve been a consistent bill payer, call your credit card company and ask them to lower your interest rate or even drop any fees associated with your card.
  • If you don’t pay your bill in full after 3 months, cut your cards up or stick them in the freezer. By the time they thaw out your urge to buy may have subsided!
  • Itemize your credit card charges in your checkbook – every time you make a charge, enter it into your check register. That way you’ll have accounted for all your charges and can pay off the bill in full at the end of the month.
  • Nix the cash advance privilege – getting cash by using the cash advance privilege on your credit card can be an extremely expensive way to get cash quickly. Depending on the terms of your credit card, you may be charged a different or higher interest rate for the cash you borrow. Try limiting use of the cash advance privilege to emergency uses only.
  • Ask a friend or a family member to keep you “in check.” If you have a trusted friend or family member who is good with money, consider asking them to help you out by going over your credit card bills every month. There’s nothing better to motivate some people to keep their spending under control if they know someone else will be taking a look at their bill!

The key to remember is that credit is not a source of free money! Establishing and maintaining good credit is an important part of wisely planning for your, and your family’s, financial future.