Credit represents a form of trust established between a lender and a borrower. If the lender believes that a prospective borrower has both the ability and the willingness to repay money, then credit will be extended. The borrower is expected to live up to that trust by repaying the lender. For the privilege of borrowing, a lender requires that a borrower pay interest and some other charges, such as processing fees. One can distinguish between good and bad uses of credit. Among the good uses are mortgage loans to buy a home, loans to open a business, and student loans. These uses are seen as wise choices because the funds are invested in ways that have a longterm payoff. Bad uses of credit include using a credit card to support a lifestyle that you could not otherwise afford and taking out loans to buy overly expensive and otherwise unaffordable vehicles
Good Uses of Credit
Credit can be used in very positive ways to enhance personal financial planning. Following are some of the reasons people use credit:
Good Uses of Credit
Credit can be used in very positive ways to enhance personal financial planning. Following are some of the reasons people use credit:
1. For convenience. Using credit cards simplifies the process of making many purchases. It provides a record of purchases, and it can be used as leverage if disputes later arise. Convenience use of credit is growing. For example, many of us now use credit cards at the grocery store and the gas station. Convenience use is justified only if the card balance is paid in full each month, however. After all, you do not want to be paying for today’s restaurant meal for months or years in thefuture.
2. For emergencies. Consumers may use credit to pay for unexpected expenses
such as emergency medical services or automobile repairs.
2. For emergencies. Consumers may use credit to pay for unexpected expenses
such as emergency medical services or automobile repairs.
3. To make reservations. Most motels, hotels, and car rental agencies require some form of deposit to hold a reservation. A credit card number can serve as such adeposit, allowing guaranteed reservations to be made over the telephone. In many cases, the hotel will notify the credit card issuer to put a hold on your account for the anticipated total amount of the charge. This process is called credit card blocking
4. To own expensive products sooner. Buying “big ticket” items such as a computer or automobile on credit allows the consumer to enjoy immediate use of the product. Many expensive items would not be purchased (or would be bought only after several years of saving) without the opportunity to pay for them over time. The expected life of the product should be at least as long as the repayment period on the debt
5. To take advantage of free credit. Merchants sometimes offer “free” credit for a period of time as an inducement to buy. Known as “same as cash” plans, these programs allow the buyer to pay later without incurring finance charges. The free credit lasts for a defined time period, but interest may be owed for the entire time period if the buyer pays even one day after the allotted free-credit period ends.
6. To consolidate debts. Consumers who have difficulty making credit repayments may resort to a debt-consolidation loan, through which the debtor exchanges several smaller debts with varying due dates and interest rates for a single large loan. Even when the debt-consolidation loan has a higher interest rate, the new payment can be smaller than the combined payments for the other debts becausethe term of the new loan is longer than the terms of the old ones
7. For protection against rip-offs and frauds. Internet and telephone purchases made on a credit card can be contested with the credit card issuer under the guidelines of the Fair Credit Billing Act (discussed later).
4. To own expensive products sooner. Buying “big ticket” items such as a computer or automobile on credit allows the consumer to enjoy immediate use of the product. Many expensive items would not be purchased (or would be bought only after several years of saving) without the opportunity to pay for them over time. The expected life of the product should be at least as long as the repayment period on the debt
5. To take advantage of free credit. Merchants sometimes offer “free” credit for a period of time as an inducement to buy. Known as “same as cash” plans, these programs allow the buyer to pay later without incurring finance charges. The free credit lasts for a defined time period, but interest may be owed for the entire time period if the buyer pays even one day after the allotted free-credit period ends.
6. To consolidate debts. Consumers who have difficulty making credit repayments may resort to a debt-consolidation loan, through which the debtor exchanges several smaller debts with varying due dates and interest rates for a single large loan. Even when the debt-consolidation loan has a higher interest rate, the new payment can be smaller than the combined payments for the other debts becausethe term of the new loan is longer than the terms of the old ones
7. For protection against rip-offs and frauds. Internet and telephone purchases made on a credit card can be contested with the credit card issuer under the guidelines of the Fair Credit Billing Act (discussed later).
8. To obtain an education. The high cost of education has forced many students to use student loans. This may be one of the better uses of credit, as the borrower is investing in himself or herself to raise the quality of life and/or income in the future.
The Downside of Credit
Despite its benefits, the use of credit has a downside. Negative aspects include interest
costs, the potential for overspending, credit’s negative effect on your financial flexibility,
and concerns about privacy.
Use of Credit Reduces Financial Flexibility The greatest disadvantage of credit use comes from the loss of financial flexibility in personal money management. The money that you pay each month on your debts is money you could have spent elsewhere on other opportunities. Credit use also reduces your future buying power, as the money you pay out on a loan includes a finance charge as well as the principal. In fact, credit can be seen as a promise to “work for the creditor” in the future to pay off the debt Overindebtedness can be a real problem for credit users. Consumers with monthly nonmortgage debt repayments amounting to 16 percent of monthly take-home pay ormore are considered to be seriously in debt. Misusing credit and not paying bills on time can give a consumer a poor credit reputation, damage employment prospects, increase the rates paid for insurance, and sometimes result in the loss of items purchased.
Interest Is Costly Interest represents the price of credit. It is Qthe “rent” you pay while you use someone else’s money. When stated in dollars, interest makes up part of the finance charge, which is the total dollar amount paid to use credit (includinginterest and any other required charges such as a loan application fee). The Truth in Lending Act requires lenders to state the finance charge both in dollars and as an Knowing the APR simplifies making comparisons among credit arrangements. The lower the APR, the lower the true cost of the credit. The APR can be used to compare credit contracts with different time periods, finance charges, repayment schedules, and amounts borrowed. Many states have usury laws (sometimes called small loan laws) that establish the maximum loan amounts, interest rates, and creditrelated fees for different types of loans from various sources. These maximum rates can vary from 18 percent to as much as 54 percent. The laws of the state in which the lending institution is located apply, rather than the laws of the state in which the borrower lives. These regulations apply to the annual fee, late payment fee, and other fees charged on a bank credit card.
Despite its benefits, the use of credit has a downside. Negative aspects include interest
costs, the potential for overspending, credit’s negative effect on your financial flexibility,
and concerns about privacy.
Use of Credit Reduces Financial Flexibility The greatest disadvantage of credit use comes from the loss of financial flexibility in personal money management. The money that you pay each month on your debts is money you could have spent elsewhere on other opportunities. Credit use also reduces your future buying power, as the money you pay out on a loan includes a finance charge as well as the principal. In fact, credit can be seen as a promise to “work for the creditor” in the future to pay off the debt Overindebtedness can be a real problem for credit users. Consumers with monthly nonmortgage debt repayments amounting to 16 percent of monthly take-home pay ormore are considered to be seriously in debt. Misusing credit and not paying bills on time can give a consumer a poor credit reputation, damage employment prospects, increase the rates paid for insurance, and sometimes result in the loss of items purchased.
Interest Is Costly Interest represents the price of credit. It is Qthe “rent” you pay while you use someone else’s money. When stated in dollars, interest makes up part of the finance charge, which is the total dollar amount paid to use credit (includinginterest and any other required charges such as a loan application fee). The Truth in Lending Act requires lenders to state the finance charge both in dollars and as an Knowing the APR simplifies making comparisons among credit arrangements. The lower the APR, the lower the true cost of the credit. The APR can be used to compare credit contracts with different time periods, finance charges, repayment schedules, and amounts borrowed. Many states have usury laws (sometimes called small loan laws) that establish the maximum loan amounts, interest rates, and creditrelated fees for different types of loans from various sources. These maximum rates can vary from 18 percent to as much as 54 percent. The laws of the state in which the lending institution is located apply, rather than the laws of the state in which the borrower lives. These regulations apply to the annual fee, late payment fee, and other fees charged on a bank credit card.
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