Stories abound about the wonders of credit and its woes. Without creditThe borrowing capacity of an individual or company. A transaction in which a borrower (or debtor) receives goods, services, or cash and agrees to repay the lender at a future date, usually with certain costs., few people would ever know home ownership, purchase a vehicle, or even attend college.
With personal lines of credit, people have been able to start successful businesses — something not always possible without having a large sum of savings in the bank. But credit and its misuse have also sent people deep into debt and even bankruptcy proceedings. (Note: for more on bankruptcy, see the Bankruptcy section).
Understanding Costs and Benefits of Using Credit
Credit has various meanings for different people. One person can view credit as the key to financial happiness and prosperity and another can view it as the road to debt and despair. However you look at it, credit enables you to obtain and use money that you do not currently have. For many people, having credit means being able to purchase a car with a small down payment or obtain a mortgage loan to buy a condo or a student loan to pay for higher education.
What is expected in return for borrowing money on credit?
The money will be repaid with interest and fees, and within a certain time period.
No matter how you feel about credit, or whether you choose to use it, its important to have the knowledge, information, and skills to be able to use credit wisely. In most cases as your income grows, so will your access to larger amounts of credit. However, no matter what your income level is, you should still be thinking about and actively developing a good credit history and credit scoreNumeric value compiled from information in a credit report using a standardized formula that ranks the risk of default according to the person’s credit history. A score is based on past payment history, the amount of credit available, and other factors. .
Finally, even with access to credit, remember it is up to you to understand how much credit really costs and to comparison shop for credit (i.e., compare interestAn amount of money paid for using funds over a period of time, generally an annual percentage rate. Bank interest is both an amount paid to depositors of funds and a finance charge for money that is borrowed. The price that someone pays for the temporary use of someone else’s funds. Interest is also a compensation that someone receives for temporarily giving up the ability to spend money. and fees).
- Credit makes it possible to buy and enjoy expensive items while still paying for them.
- Credit provides convenience when traveling and purchasing by mail or Internet.
- Credit facilitates the handling of financial emergencies.
- Purchases cost more due to interest and fees; consumers might be tempted to overspend, have a false sense of security.
- Risk possible poor credit ratingA formal evaluation of an individual’s or business’ credit history and capability of repaying obligations by a credit reporting agency. The credit rating is based on the number of outstanding debts and whether debts are being repaid in a timely manner. , future earnings are committed.
- Credit abuse such as shopping frenzies, purchase of unneeded goods or services, living beyond one’s income.
- Predatory lending such as excessively high interest, packing a loan with unneeded extras, misrepresenting critical loan details.
The Three C’s of Creditworthiness
One way lenders may measure your creditworthiness (the likelihood you will repay them) is through the three C’s:
- Is the person trustworthy?
- Does the person have sufficient resources to give to the lender in case he or she cannot make payments on a loan?
- Is the person capable of repaying the loan?
The Vocabulary of Credit
It is important to remember “all loans are not equal.” Loans incur a range of interest rates and fees from low cost to high cost. In order to secure the best loan possible it is important to familiarize yourself with basic credit vocabulary.
Annual Percentage Rate or APR is a rate that shows the total cost of credit annually. It includes a percentage of the principalThe original sum borrowed. as interest on a loan plus other costs (e.g., points on a mortgage loan, service charges).
A creditor is the lender or supplier of money, goods, services, or securities.
Finance charge is the cost of credit, including interest paid by a customer or a consumer for a consumer loan. Under the Truth in Lending Act, the finance charge must be disclosed to the customer in writing.
Interest is an amount of money paid for using funds over a period of time, generally an annual percentage rate. Bank interest is both an amount paid to depositors of funds and a finance charge for money that is borrowed.
Credit limit is the maximum amount a bank will loan based on a person’s credit rating.
Minimum payment on a loan is a certain percentage of the balance due, paid at regular intervals.
Overlimit fees are levied for charges exceeding one’s credit limit.
Look Before You Lease
The Federal Trade Commission (FTC) website provides shopping tips and pointers for leasing a car, including:
- common leasing vocabulary
- what questions to ask
Real Life Scenario: Shopping for a Car
It is important to research and analyze the choices to be made when it is time to purchase an automobile. Your personal needs and values could impact your decisions. Decide whether to get a new or pre-owned car. Consider the primary purpose for the vehicle (is this a family car or for commuting to work?) along with any features that are important to you, such as gas economy. Select the make and model of the vehicle based on your needs along with any accessories. Before you make the jump, you will need to compare buying and leasing.
Leasing vs Buying
Leasing a car is not the same as buying one. When you buy, you own the car. When you lease, you pay to drive a car owned by a finance company or dealership (the lessor).
Leasing can involve lower monthly payments than a loan on a new car. However, when the lease terminates you must either return the car to the lessor or pay a given amount to buy the car.
When buying a car on credit, look for the lowest APR you can find. You should know the amount that you need to borrow (principal of the loan) and the number of years in which you want to repay the loan. Calculate the total cost of the automobile by adding the finance charge to the list price.
Remember, when buying a car on credit, steep depreciationA loss or decrease in value, especially because of wear or age (e.g., the depreciation of a new auto). in the first few years could result in more money owed on the vehicle than the price at which it could be sold.
Compare differences in the amount of down payment to lease it or to buy it. Remember to also compare insurance requirements on a leased or purchased automobile (e.g., what coverage is required).
Once you have all this information, you will be better equipped to make a decision on leasing vs. buying your next vehicle.