University of Idaho Extension

Making Choices About Credit

Loan graphic

USING credit WISELY

Knowing how much credit you can afford on a monthly basis and recognizing the "real" cost of buying on time are vital to your financial well-being.

Used wisely, credit can be a valuable tool. By helping you accumulate assets, it can contribute to your financial future. Used poorly or abused, it can tie up future income and leave you with too many debts. For better or worse, credit has become a necessary convenience in modern lives: to rent a car or reserve an airline ticket or hotel room, you'll need a credit card.

When you receive credit, you're promising to repay the amount you borrowed and make each of your scheduled payments on time. You're also promising to pay interest and other finance charges, which may include debt-related services and insurance. Knowing how much credit you can afford on a monthly basis and recognizing the "real" cost of buying on time are vital to your financial well-being. Before borrowing, become familiar with your personal financial picture and never spend more than you can repay.

There are four types of credit:

  • Sales or installment credit lets you buy goods. It's offered by car dealers, department stores, and furniture shops, among others.
  • Loans of cash are usually available through a bank, credit union, or finance company. You typically use them to meet unexpected expenses, make major purchases, or pay off other debts.
  • Credit cards allow you to have goods or services—even cash—immediately. They're generally offered through banks but are also available from businesses and other types of financial institutions.
  • Service credit is extended by doctors and utility companies.

Credit can be either closed-end or open-end:

  • Closed-end accounts extend to you a specific amount of money over a set period of time. The payment period, payment amount, and number of payments remain fixed for the life of the agreement. You can't add more purchases or loans to the original balance. Consumers often use this type of account when buying vehicles, major appliances, and homes as well as for some personal loans.
  • Open-end accounts let you make repeated purchases or get cash up to a specified limit through an ongoing agreement with the creditor. Some agreements require that you pay off the full balance each month. Others let you make a minimum monthly payment, adding a finance charge for interest and other fees to your balance. Examples of open-end credit include revolving charge accounts, credit cards, lines of credit, and checking accounts with overdraft protection.

advantages and disadvantages of using credit

The advantages of using credit include:

  • You can build a solid credit history with the record of payments you make.
  • You can get goods and services before you pay for them.
  • You can make large purchases without waiting.
  • Using credit can help build your history
  • You can meet emergency needs or get emergency cash.
  • You don't need to carry large amounts of cash.

But using credit also has disadvantages:

  • You'll generally pay extra for the item you're buying because of the interest and finance charges.
  • You're spending future income, living on money you expect to have down the road. If you lose your job or get sick and don't make the future income you expect, your inability to repay your debts will damage your credit rating.
  • You may overspend. It's easy to lose track of how much you've spent when the bills don't come for a month.
  • You may be tempted to buy on impulse because it doesn't feel like you're spending "real" money.
  • You run the risk of ending up in a downward spiral of debt and even in bankruptcy.

Before you decide to use credit, ask yourself:

  • Do I really need this item now or can it wait until I have saved for it?
  • What are the extra costs of buying this item on credit?
  • Is having this item now worth those extra costs?
  • Can I make the monthly payment as scheduled?
  • To use credit now, what will I have to give up in the future?
  • Will I be able to handle an emergency if one comes up?

Comparing Credit Card Offers

If you decide to use credit, shop around. To make sure the card you accept offers the best possible deal, do your homework and compare several credit card offers. Be sure that you understand such credit card terms as:

  • Application fee
  • Annual fee
  • Billing cycle (when your payment is due)
  • Annual percentage rate, or APR (the percentage you pay, per year, in interest and fees)
  • Fixed or variable APR (whether the rate stays the same or varies)
  • Cash-advance and other transaction fees
  • Grace period (how much interest-free time you have between the day you make your purchase and the day your payment is due)
  • Compare credit card offers
  • Leniency period (how much time you have between the day the payment is due and the day a late fee is assessed)
  • Late-payment fee (how much extra you must pay if your payment is late)
  • Over-the-limit fee (how much extra you must pay if you exceed your credit limit)
  • Penalty APR (how much your APR will increase if you're late or miss a payment)
  • Minimum payment allowed (%)
  • Benefits (such as points earned)
  • Credit limit

Examine each card's costs and terms and think about your typical bill-paying behavior. Do you pay your outstanding balance in full each month? Or do you usually carry over a balance and run the risk of paying interest on your interest? Matching the credit card plan to your needs could save you money. Use our credit card comparison worksheet to select the credit card that's best for you.

Common Credit Card Traps

Beware of traps that can drive up the cost of using credit:

  • Hidden transaction fees: Does the company charge for cash advances, balance transfers, and quasi-cash transactions like lottery ticket purchases?
  • "Tiered" pricing: Does the company offer you a range of Annual Percentage Rates (APRs)? This can work against you if the company bases your APR on your credit history and inflates your rate accordingly.
  • "Teaser" rates: To entice customers to switch credit cards or lenders, many companies offer below-market interest rates if you accept "before the offer expires." While these low introductory rates may sound good, they often increase steeply in three to six months or apply only to the balance you transfer from another card.
  • "Bait-and-switch" offers: If you don't qualify for the company's premium credit card, will you automatically be switched to a lower-grade card that costs more and offers less attractive terms?

The High Costs of Low Minimum Payments

A minimum monthly payment of 2% of the balance may sound attractive to you, but beware! You'll pay more in interest as you take longer to pay off the current balance. If your beginning balance is $2,000 and your Annual Percentage Rate (APR) is about 15%, notice the impacts of stretching out your payments:

Monthly Payment Months to Pay Off Balance Total Interest Paid
2% 169 (14 years) $2,205.63
5% 65 (5.5 years) $589.74
10% 36 (3 years) $269.31

How long you take to repay a loan is an important decision. The more time it takes, the more it will cost you. If you borrow $4,000 at an APR of 12% for two years, your total interest cost will be $519. If you repay the same amount—at the same interest rate—over four years, the total interest paid will jump to $1,056. Of course, your monthly payments will be lower over four years—in this case, $105 instead of $188—but you'll need to decide if the lower monthly payment is worth the extra interest. Try to make the largest payment you can for the least amount of time.

Credit Card Legislation

The Credit Card Reform Act of 2009 went into effect in February 2010:

  • Gives cardholders 45 days' notice before credit card companies can increase your interest rate, fees, or finance changes
  • Prevents credit card companies from increasing rates to cardholders who carry balances until you're late by 60 days or more—and restores your old rate after you've paid on time for the next six months
  • Prohibits fees for over-the-phone payments unless you speak directly with a live operator
  • Restricts over-the-limit fees to three times for a single infraction and bans them entirely unless cardholders "opt in" to exceed their credit limits
  • Requires consumers who are 21 and under to either show that they have an independent source of income or provide a co-signer
  • Compels banks to apply payment in excess of the minimum amount to balances with the highest interest rate, such as cash balances, ATM withdrawals, balance transfers, etc.

There's other good news for consumers in this legislation as well. You'll have more time to pay your bills, because companies must send statements at least 21 days before the due date. You can't be charged a late fee if the due date is a Sunday or holiday and your payment arrives the next day. And you'll get timely information to help you manage your debt: each bill will include a running tally of your interest and fees for that year and spell out how long it would take you to pay off your balance if you made only minimum payments.

Preserving Your Credit Limit

A credit limit is the maximum total amount—for purchases, cash advances, balance transfers, fees, and finance chargers—that you may charge on your credit card. If you go over this limit, you may have to pay an "over-the-credit-limit fee."

Since the 2008 economic downturn, credit card companies have been taking steps to rein in their risk by reducing credit limits, even for reliable, long-standing cardholders. Here's an example: If you have a credit limit of $10,000 and a balance of $4,000, your "credit utilization rate" is 40% ($4,000/$10,000 = 40%). But if your credit card company lowers your credit limit to $5,000 because it worries that you may default, your credit utilization rate will increase steeply to 80% ($4,000/$5,000 = 80%). Not only does this credit "squeeze" reduce your access to financing, but your higher credit utilization rate can damage your credit score. You can maximize your chances of preserving your credit limit by:

  • Paying down your balance as much as you can—to less than 50% of the credit limit, if possible
  • Distributing your charges across several credit cards (but don't open new credit unless you really need it)
  • Curbing your impulse to cancel cards you don't regularly use; the closed account will lower your total available credit and could shorten your credit history
  • If your credit is squeezed, calling your issuer directly with a reminder that you're a good customer they don't want to lose

Debit Cards

Debit cards look like credit cards but work differently. They are "pay now" products that quickly debit, or subtract, money from your checking or savings account, as if you were taking out cash. So, for your debit card to work, you must already have the money in your account to cover the transaction. By comparison, credit cards are "pay later" products that draw from a credit line made available by your card issuer.

There are three types of debit cards:

  • Direct debit cards require the use of a PIN (personal identification number).
  • Deferred debit cards are signature-based, carry a VISA or MasterCard logo, and deduct the purchase from your account in two or three days.
  • Combination debit cards offer both debit functions on the same card.

Debit cards have several benefits:

  • Payment convenience: You don't have to carry a checkbook or large sums of cash.
  • Merchant acceptance: Debit cards are more accepted than checks.
  • Fast payment process: There are no checks to write at the sales counter.
  • Easier qualification: Because debit cards use your own money at the time of sale, they are often easier to obtain than credit cards.

You can use debit cards at ATMs for no fee (inter-system) or for a small fee (out-of-system).

If you're making a purchase with a debit card, be aware that—unlike with a credit card—there is no grace period. Make sure you have the money available to cover the full transaction amount at the time of sale. Because some debit cards have monthly or transaction fees, it's also important to review your cardholder agreement carefully.

Tips for debit card use:

  • Choose a PIN that a smart thief can't figure out. Avoid obvious choices, such as your address, phone number, or birth date.
  • Keep your PIN private. Memorize it, do not write it down, and never tell it to anyone.
  • Know your current account balance. Don't forget about checks that have not yet cleared your account.
  • Always take your sales receipts and carbons. They may contain valuable information a thief could use to make mail, phone, or Internet purchases on your account.
  • Record your transactions in your check register as soon as possible. Remember to include any debit card fees that may apply. Then store your receipts safely in one place in case you need them later.
  • If your card is lost or stolen, contact your card issuer immediately. This reduces your liability if fraud losses occur.

Debit or Credit?

  • Debit cards are "pay now" and credit cards are "pay later."
  • Credit cards offer additional protections against fraud when used for Internet purchases.
  • Debit cards may be best for small purchases and credit cards for larger purchases.

Payday Lending

What payday lenders market to consumers is the "easy-money" promise of a one-time, two-week cash advance. But payday loans require full repayment in a short period of time—with no option for installment pay—so borrowers often renew them again and again. Each time, they pay a hefty fee. In Idaho the average Annual Percentage Rate (APR) of a payday loan is a whopping 582% but can range to more than 1,000%, depending on the duration of the loan and the legal limits of the state in which the loan occurs.Payday loans can have outrageous interest rates

Payday loans are secured by the borrower's signed personal check, which is dated on the borrower's next payday, or by using a future paycheck as collateral. Because borrowers fear the consequences of bouncing the check they've left with the lender—including potential criminal prosecution for writing a "bad" check—they agree to take out "rollover" or "back-to-back" loans. As the fees for these additional loan transactions add up with every payday, borrowers find it harder and harder to repay the loan principal.

There are tens of thousands of payday lenders—including check-cashing stores, pawnshops, and online outlets—in the U. S. today. A new Idaho law, SB 1314, took effect July 1, 2014. It limits borrowers taking out payday loans to an amount not to exceed 25% of their gross income, with the borrower to provide the proof of that; and requires lenders to offer borrowers who can't repay their loans on time a once-a-year option for an extended payment plan without additional fees. Your best protection against payday lending is having your own emergency fund or taking out a short-term loan from a local bank or credit union.

Developed by:

Marsha Lockard
University of Idaho Extension Educator-Owyhee County
P.O Box 400 (238 8th Avenue West)
Marsing, ID 83639
(208) 896-4104
mlockard@uidaho.edu

Marilyn Bischoff
University of Idaho Extension Professor and Family Economics Specialist
322 E. Front St., Ste. 180
Boise, ID 83702
(208) 364-9910
mbischof@uidaho.edu

2014 Update by:

Nancy M. Porter, Ph.D.                                                                                          Extension Personal and Family Finance Consultant Consultant                                 University of Idaho                                                                                                            (864) 650-8289                                                                                  nporter@uidaho.edu

 
Other credits:

Educational Communications,
University of Idaho College of Agricultural and Life Sciences:
Editing: Marlene Fritz, Communications Specialist, Boise
Web Design: Jacob Peterson, Web Designer, Moscow

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