Updated: Jan 26
Knowing how to use credit wisely is basic to our overall financial health. Because credit can be a great help when used properly, but when used poorly, it can adversely affect your financial future.
What is Credit?
Credit is an agreement between a lender and a borrower in which a borrower receives a sum of money or something of value and repays the lender the amount borrowed plus interest throughout an agreed-upon time. Lending institutions offer a whole range of credit facilities for your convenience and repayment capacity.
Types of Credit
All credit extended by lending institutions falls under three main types: installment loans, revolving credit, and available credit.
Installment loans involve borrowing a lump sum and repaying the loan principal plus interest in regular fixed payments at regular intervals over a certain amount of time. Once the loan is completely paid off, the lender considers the account closed. Examples of Installment loans include auto loans, mortgage loans, home equity loans, personal loans, and student loans.
You can secure some installment loans against collateral. For example, a vehicle loan may use the vehicle as collateral. A mortgage loan has the house as collateral. In the event of default, the lender can foreclose on the house. In the case of an auto loan, the lender can seize the vehicle to recoup some of the loan amounts.
Revolving credit is when the lender extends a maximum amount, and you can repeatedly borrow and repay amounts up to the maximum limit. As a result, you’re in control over how much you borrow (and ultimately need to pay back) and how much you pay back, and when you make your payments, which means it’s possible to avoid paying interest if you pay your balance in full each month.
Interest with revolving credit can be variable or fixed. And with some revolving credit facilities, you only need to pay the interest on the credit facility. With some others, as with credit cards, your minimum payment each month is three percent of the outstanding balance plus interest.
With some types of revolving credit, as long as you make all your payments on time, the account will remain open indefinitely until you close it. Credit cards are the most common type of revolving credit.
Monthly payments vary with available credit, and balances are due in full at the end of each billing cycle. Available credit includes your utility bills — gas, electricity, water, cable, and cell service. The amount due usually depends on how much you use that month. The entire bill is due within a few days of receiving it.
Lenders lend loans that can be either secured or unsecured. Any collateral does not back unsecured loans; they are generally for lower amounts and with higher interest rates. Whereas secured loans are backed by collateral — for example, the house or the car that the loan is used to purchase. Below is a list of common types of loans issued to borrowers by lenders:
A mortgage is a loan to purchase a home or other real estate, and the loan lender uses the property as collateral. Once a lender approves you for a mortgage, you pay the down payment (a portion of what the property is selling for), and the lender pays the rest, leaving you to pay back the mortgage loan with interest payments over several years (known as the amortization period) until the mortgage is paid.
Should you fail to make the payments, the lender has the right to sell the home and recoup the loan amount. Because they are large loans, most mortgages have an amortization period (payback period) of about thirty years. In addition, since mortgages are secured by real estate (something perceived as valuable), they tend to come with lower interest rates than other loans.
Like mortgages, automobile loans are installment loans. The collateral, in this case, is the vehicle the borrower wishes to purchase. The lender advances the amount of the purchase price to the seller — less any down payments made by the borrower. If the borrower defaults, the lender can repossess the vehicle. Often, car dealerships or automakers will offer to serve as the lender.
Debt Consolidation Loans
As the name implies, a debt consolidation loan consolidates all other debts into one. Upon approval, the loan pays off all the outstanding debts. Instead of multiple payments for numerous debts, the borrower is only responsible for one regular payment to the consolidation loan lender.
Home Improvement Loans
As the name suggests, a borrower applies for a home improvement loan to repair or improve their home. This type of loan may or may not be secured by real estate. If they are large in amount, your lender will secure them against your home. And small home improvement loans are typically not secured against the home. However, often these improvements will likely increase the value of their home.
According to the Education Data Initiative: 42.8 million borrowers have federal student loan debt. The average balance is $37,787, while the total average balance (including private loan debt) may be as high as $40,780.
Also known as education loans, government and private lenders offer these types of loans. To qualify for a private loan often requires the income and credit rating of the student’s parents rather than the student since, typically, the student is still young and does not have a long lending or employment history. What is unique with this type of dent is that repayments are typically deferred till six months after graduation.
The loans above were for individuals. This category, business loans, also known as commercial loans, are credit issued to businesses (small, medium, and large). Business owners get these loans for capital to buy machines, inventory and hire staff. Lenders usually charge application and origination fees in addition to interest.
Lines of Credit
Lines of credit are similar to credit cards. However, a line of credit is a form of revolving debt and works differently from loans. When the lender (the bank or financial institution) advances a line of credit to you, it provides you with an account with a set credit limit that you can use repeatedly.
Because it is a form of revolving credit, it is a much more flexible borrowing tool. Unlike loans used for a specific need, you can use lines of credit for any purpose: a wedding, travel, a child’s education, minor renovations, or paying down high-interest debt. How can you access your line of credit?
The Benefits of Lines of Credit
You can access your line of credit funds by transferring the available balance to your checking account or with a debit card or by writing checks against it. You can access your line of credit whenever needed as long as regular minimum payments have been made on time and credit is still available.
For example, if you have a line of credit with a credit limit of $10,000, you can use part or all of it for whatever you need and whenever you need it. You can use $3,000 today to pay for a trip. And have $7,000 available credit for a future purchase. If you pay off the $3,000, you can reaccess the entire $10,000.
Because of their flexibility, lines of credit tend to have higher interest rates, lower dollar amounts, and smaller minimum monthly repayment amounts than loans. Like loans, payments comprise both principal and interest. But unlike loans, the payments vary each month depending on the outstanding balance you owe.
Your lines of credit usage impact consumer credit reports and credit scores much faster and more significantly than loans. This is because you start paying interest on your line of credit once you purchase or take out cash.
Types of Credit Lines
The three common types of credit lines: are personal, business, and home equity.
A Personal Line of Credit
This is a line of credit that does not require any collateral. As such, a borrower needs to have a higher credit score to qualify for this. Personal lines of credit usually come with a lower credit limit and higher interest rates. Most banks issue this credit to borrowers indefinitely.
Because of its flexibility and ease of access, lines of credit can be easily abused. If you want to know how to use credit wisely, you must limit your line of credit usage. Many people live on their line of credit. Remember that it is still debt.
A Business Line of Credit
As the name implies, these credit lines are used by businesses. However, instead of a personal credit score, the bank or financial institution lending the line of credit considers the company’s market value, profitability, and risk.
Lenders can evaluate the credit risk and creditworthiness of the business by looking at their financial statements over the past two or three years. Then, depending on how much credit a business owner needs and the type of business, a business credit line can be secured or unsecured.
Home Equity Line of Credit (HELOC)
Home equity lines of credit (HELOCs) are secured against the market value of your home. When determining the credit limit for a HELOC, lenders factor in how much the borrower still owes on the mortgage. Most lenders would usually advance a line of credit up to 80% of a home’s market value less the amount still owing on your mortgage.
In the US, most home equity lines of credit come with a specific draw period — the period you can draw from. And this is usually up to 10 years. During this draw period, you can use, pay, and reuse the funds repeatedly. In addition, because they are using the home as security, lenders usually charge a lower interest for a HELOC than a personal line of credit.
At the end of the draw period, you can no longer use the HELOC. Instead, it converts into a fifteen-year loan. These monthly payments comprise both principal and interest. The interest on secured loans and lines of credit is generally lower than on unsecured loans and lines of credit. However, because lines of credit are revolving credit facilities, the interest rate is generally higher than a loan with a fixed payback period.
According to data from the credit bureau agency Experian, the average American has an average of 3.84 credit cards in the third quarter (Q3) of 2020.
By the end of 2021, Americans owed $841 billion on their credit cards. The average American credit card debt is $5,221. The average interest rate on credit cards is 16.4%.
Based on this balance owing, if you spent another dollar and all you did was pay the minimum each month — which is 3%, it would take you 39 months to pay off. It would cost you about $1547.00 in interest payments for that duration.
How to Get Out of Credit Card Debt:
● Use your credit card sparingly — only to book flights and hotels. ● Make a plan to pay off the balance on your credit card by trimming your budget. Reduce spending where you can. ● Your credit card is a form of revolving debt, making it hard to pay it off. Keep only one card and cancel the rest. ● As much as possible, prepare home-cooked meals instead of eating out. ● If your credit is clean, consider transferring the balance on your credit card to one offering a lower interest rate. Don’t be tempted to rack that up. ● If you have substantial revolving debt, consider getting a consolidation loan. They have a fixed payment amount and length of time for which to pay it off. ● Negotiate a lower interest rate on your credit card with your bank. ● If you find it challenging to pay off your credit card due to extenuating circumstances such as job loss or illness, seek credit counseling. Keeping a balance on your credit card is a drain on your finances. Not to mention that missing payments can impact your credit score. And in a rising interest environment, this can only get worse. Debt robs you of your financial future.
How to Avoid the Debt Spiral
It is much easier to avoid getting into debt than trying to pay it off when it snowballs. One of the best ways to avoid debt is to build an emergency fund equal to six to twelve months of income.
Unfortunately, most people get into debt because of unplanned financial emergencies. Building savings to deal with curveballs is a great way to prevent from entering a debt spiral. And curveballs occur even to the best of us.
How to Use Credit Wisely
Credit is a great way to pay for something when you don’t have the resources to pay for it. If your income is irregular, credit could be an efficient way to bridge the gap between when you need to purchase an item and when you get paid. However, it becomes a problem when you can’t pay for it by the end of the month and are now adding interest to the original purchase price.
You need your credit card to make most hotel and airline bookings. Many businesses ask for your credit card to verify your identity. Credit cards are handy as a backup form of payment. If someone were to rob you of your cash while you were on vacation, you would be happy if you had a credit card as a backup form of payment.
Credit is a necessary part of your financial life. Establishing good credit allows you to borrow at a lower rate than someone with poor credit. Using credit wisely is part of a healthy relationship with money.