Credit

Credit is a valuable financial tool but must be used wisely. Not using credit wisely can impact your ability to get a loan, obtain employment, housing and increase your cost for services like insurance.

What Is Credit?

Credit is the ability to borrow money or access goods or services with the understanding that you will make payments as expected. Your credit history is a record of when you have borrowed money and made payments or when you failed to make payments you had agreed to make. Having good credit means you have a history of borrowing money and repaying it on time. If you are unsure of any terms used below, review our Basic Financial Terms page.

Credit Report

Your credit report is a record of your credit history. These reports are compiled by credit bureaus. Credit bureaus are companies that specialize in recording credit history. Your credit report shows:

• The number of credit card accounts you have or have had, their borrowing limits, and current outstanding balances.
• The amounts of any loans you have taken and how much you have paid back.
• Whether your monthly payments for your accounts were made on time, late, or missed.
• How many credit applications you have submitted in the past two years.
• Severe financial setbacks such as foreclosures, repossessions, and collection accounts.

Using your credit report, the credit bureaus assign you a three digit number known as a credit score. This score ranges from 300 to 850. Higher numbers are better and mean you are more likely to be approved and receive lower interest rates. Your credit score will change regularly based on how the information in your credit history changes. Your credit score is based on:

• How many payments you have made on time. Making late payments or missing payments will reduce your credit score.
• How long you have had credit card accounts and loans. 
• How many credit and loans accounts you have had. 
• How often you apply for credit.
• The balances on your credit cards and loans particularly in relation to your borrowing limits. Keeping your balances low will increase your score.
• How much credit you have available to you to use.
  

Credit Cards

Credit cards allow you to borrow money to make purchases. When you are approved you will be given a credit limit meaning you can borrow up to your credit limit. Your available credit is your credit limit minus any amount you have borrowed and not yet repaid. You will receive a billing statement monthly that shows how much you have borrowed and the minimum amount you have to keep your account in good standing. The minimum amount due is typically between 2% and 5% of your total balance or amount borrowed.

There are two main types of credit cards: secured and unsecured.

A secured credit card means you have to provide funds to secure your borrowing ability. Your credit limit will be equal to the amount of funds you provide. You are still borrowing against that fund and that fund will be unavailable to you until you either close the account or meet the terms to convert the account to an unsecured account. 

An unsecured card means you do not have to provide money to secure your borrowing ability. Your credit limit will be determined by the financial institution approving the credit card account and is typically based on your income and credit history.

Credit cards charge interest on the amount you borrow. Interest is a percentage of what you borrowed that is charged to you for borrowing. This is usually referred to as an annual percentage rate or APR. The APR on credit cards is often variable meaning it can increase or decrease from month to month. If you pay the amount you borrowed in full each month, you can avoid paying interest. Some credit cards will offer introductory periods of 0% interest or 0% interest on purchases over a certain amount. Those offers can be helpful for making a large purchase over time without paying additional fees. Other cards offer rewards for using them like travel points or cash back. You can earn free rewards using these but only if you use them wisely. You can read about how credit card interest is calculated using the link in the resources section below.

Let's look at an example.

You are approved for an unsecured credit card with a credit limit of $5,000, 3% cash back on purchases and an annual percentage rate or 22%. In August, you decide to buy a new laptop for $500 and a new TV for $1,000. Your August billing statement shows your balance as $1,500, your available credit as $3,500, your minimum payment as $75, and your cash back rewards as $45. Let's look at 3 repayment scenarios.

If you pay the full $1,500, you will have earned $45 for making those purchases using your credit card. This is a wise way to use credit. 

If you pay only the $75, you will be charged interest for each day you are borrowing money. If you pay $75 for August, make no additional purchases and pay the remaining balance of $1,425 in September, you would pay $25 in interest. Given your cash back reward of $45, you would still have earned more than you paid.

If you pay $75 each month and make no further purchases, it would take 2 years and 2 months to repay the amount you borrowed and you would pay $386 in interest. This is $341 more than your cash back reward. In this scenario, your $1,500 in purchases actually cost you $1,841.

Our third repayment scenario is why you need to be careful using credit cards. It is easy to use credit to make purchases but if you don't have a good plan for repaying what you have borrowed, you can end up owing a lot more and it can take years to recover.

Loans

Loans can be used to make a planned purchase that you can't or don't want to make in one payment. The most common loans are student loans used to pay for college, mortgage loans used to purchase a home, and auto loans used to purchase a car. Loans are approved either based on the amount you request or the amount of the purchase you are making. Some loans require collateral. Collateral is something pledged as security that will be given to the lender if you don't make payments. Unlike credit cards, loans have a specific payment amount and repayment term or time. Your payment amount is calculated to ensure you have repaid the full amount plus interest within the repayment term.

Loans can have fixed interest rates or variable interest rates. A fixed interest rate means the interest rate will not change as long as you make the required payments. A variable interest rate means the interest rate can increase or decrease. Some lenders will have a maximum and/or minimum that your rate can increase or decrease to. Be sure to thoroughly ready your loan documents and know what type of rate you are receiving and if it is fixed, if there is a minimum and maximum it could be. 

Resources

How is Credit Card Interest Calculated?

What is a variable interest rate?