Using Credit Wisely

Before we discuss the use of credit cards, you might want to reveiw the concept of compound interest covered in Tutorial 2.

When to use credit
Recall the discussion in the first tutorial of “good” debt being used to purchase appreciating assets and “bad” debt being used to purchase depreciating assets. Some rules of thumb are:

• It's good to use credit for an appreciating asset such as a home or a business.
• It's okay to use credit to buy something that will increase your earning potential, such as a car or an education.
• It's okay to use credit when buying something that will protect an asset, like essential repairs, or protect future earnings, like work clothing, but it's best to use savings if possible.
• Credit can be used to help with cash flow problems, like when there's a short-term gap between spending and income, or for emergencies. Again, savings is best for both of these.
• Credit should not be used for comforts or luxuries, such as furniture, vacations, clothing, recreation vehicles, or regular monthly expenses.
• Credit should not be used to make up a long-term gap between income and spending.

What is credit?
Credit includes any of a number of means through which one person or institution lends another money. This is most commonly used by American consumers in the form of credit cards and loans. As discussed in chapters 2 and 3, credit is costly because you pay compound interest. Before we discuss the use of credit cards and loans, you might want to review the concept of compound interest covered in Tutorial 2.

In shopping for any type of credit, you should be familiar with the following terms:

Annual Percentage Rate, or APR, is the rate of interest you are charged, plus fees, expressed as a yearly rate. If you plan to keep a balance on your card, be sure to look for a low APR. If you expect to pay your bills on time, it will be more important to look at the annual fee and other charges. When shopping for a credit card or a loan, compare APRs rather than interest rate since APRs reflect the cost of interest and other finance charges.

Finance charge is the cost of credit. It includes interest, service charges, and transaction fees. This charge is calculated on your balance using one of a variety of methods. Knowing how your finance charges are calculated will allow you to more accurately understand how much you are paying for the money you are borrowing.

Interest rates can be either fixed or variable. With a fixed rate, the interest rate will not change. A variable rate can increase or decrease with the market rate. Make sure you understand the implications of both before you open an account.

Secured loan. A loan where the borrower offers collateral for the loan. The borrower gives up his or her right to the collateral if the loan is not paid back as agreed.

Unsecured loan. A loan where the lender does not require collateral.