Bulletin #4502, Using Credit Wisely
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Using Credit Wisely
William J. Weber, Extension resource management specialist.
For information about UMaine Extension programs and resources, visit extension.umaine.edu.
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Managing your money involves choices and decisions. An important decision in how you manage your money is what to do about credit. For many people, using credit becomes a critical part of their money management system. For most of us, credit is the one financial tool that has allowed us to buy homes, cars, and other “big ticket” items.
Credit is also used for buying other products or services, such as travel. Some people use credit when they don’t have the cash on hand for emergencies such as car problems. Indeed, there are people who use credit for nearly all their purchases, from food to fun to furniture. Using credit is convenient. It eliminates the need to carry large amounts of cash, and provides a record of purchases. These features can give you flexibility in deciding how to manage your money.
There also are some risks with using credit. Credit, or the use of it, is a promise to pay later, usually with interest, for something you buy now. If you are not careful, you can get into debt quickly. Use of credit can lead to overspending. Credit expenses can be costly and tie up money you might want to use on something else. Unwise use of credit may also lead to bad credit ratings and affect future credit-based purchases.
Can you afford more debt?
The 10 percent rule
You want to buy a freezer, but you don’t have the cash to pay for it. Can you afford to borrow the money? How do you decide?
Use the 10 percent rule. Your debt load (except for your home mortgage) should not exceed 10 percent of your yearly after-tax income.
Write down how much money you bring home each month. If you get one check a month, write down the amount of the check. If you get two checks a month, add them together for your monthly total. If you are paid weekly, add the four checks together for your monthly total.
| Example: $1000 x .10 = $100 | |
| 1. Enter your monthly take-home pay: | $ _________ |
| 2. Multiply by 10 percent (x 0.10) | = _________ |
| _______________________________________________ | |
| 3. Amount of monthly credit you can afford | $ _________ |
| 4. Compare your current monthly debt | $ _________ |
Once you have your monthly take-home pay total, multiply that by 0.10. The answer is the amount of credit you can afford.
Compare this figure to your current monthly debt payments. Is there room for a monthly payment for the freezer?
Basic types of credit
Service credit
Service credit is granted to us by public utilities for electricity, gas, telephone, and cable TV, and by health care providers for dental and medical care. Any time someone provides a service before payment is received, they have given you service credit. Bills for service credit are due shortly after the service has been provided, generally within seven to 30 days. Service credit usually carries no interest, but there might be a penalty for late payments.
Closed-end or installment credit
This means that you repay the amount owed in a specific number of equal payments—usually monthly—until the debt is repaid.
Examples:
- Car loans
- Mortgage loans
- Installment sales (refrigerators, washers, dryers, stoves)
- Installment cash credit
- Single lump-sum credit (payment due at one time)
Most installment credit has some form of collateral. It can be real property or some other tangible item of value. For a mortgage, the collateral is your home. For a car loan, it’s your car.
Open-end or noninstallment credit
With open-end credit, you are given a certain amount of credit up front. Then you can charge up to any amount that does not go over your credit limit. You repay the amount you owe either in one payment, or in a series of equal or unequal payments.
Examples:
- Credit cards. These include— department store cards such as J.C. Penney and Lane Bryant,— oil/gasoline company cards such as Mobil, Citgo, and Irving, and— bank cards like Visa, MasterCard, and Discover.
- Travel and entertainment cards like American Express and Diners Club.These cards usually require that the entire balances be repaid within 30 days or less of billing.
| Credit warning signals: |
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What is a credit card?
A credit card is a plastic card identifying you as a participant in the charge account plan of a lender such as a department store, oil company, bank, or credit union.
- Department store and oil/gasoline cards: Use is limited to a regional store or national chain of stores.
- Bank Cards (Visa, MasterCard, Discover): These are offered through banks, savings and loans, credit unions, and large consumer product companies such as AT&T and General Motors. They can be used for a wide variety of purchases, as well as cash advances.
Know the APR
The annual percentage rate, or APR, is the relative cost of credit on a yearly basis. Comparing APR of different lenders is the easiest way to compare credit. The lower the APR, the better. This is especially true for credit cards, if you do not pay your monthly bills in full.
Know the grace period
When used in reference to credit cards, a grace period is the number of days you have before a credit card company charges interest on your new purchases. A typical grace period is 20 to 25 days.
Grace periods are often misunderstood by credit card users. If you do not pay your balance in full each month, the moment you charge additional items on your credit card, some credit card companies will calculate interest on that purchase along with the unpaid balance from the previous month. To determine how an issuer treats a grace period, read the fine print on the back of your monthly statement.
How does YOUR credit card issuer calculate your interest charges?
Interest is charged on the outstanding balance on your credit card. However, credit card companies use different ways of figuring out what your outstanding balance is. This means that the amount of interest you pay could be higher or lower for the same purchases or charges, depending on what method they use. If you do not pay off your balance in full each month during the grace period, pay attention to how your credit card company calculates the outstanding balance on which interest is charged.
Average daily balance method, excluding new purchases
The sum of the outstanding balances for every day in the billing cycle is divided by the number of days in the billing cycle. Interest is charged on this average daily balance. New purchases, payments and credits are not counted.
Many consider this the most preferred method since it gives you a grace period on each new purchase—even if you are carrying a balance from the previous billing cycle.
Average daily balance method, including new purchases
The sum of the outstanding balances for every day in the billing cycle, including new purchases, payments and credits, is divided by the number of days in the billing cycle.
Two-cycle billing method
The two-cycle method calculates the average daily balance from two billing cycles instead of one, and usually results in higher interest charges. This method effectively does away with the grace period for customers who carry a balance. It can be hard to determine whether you are being billed this way. Your statement won’t say, “two-cycle billing period.” Look for language that refers to interest charged on purchases made during a previous billing cycle.
Adjusted balance method
This balance is figured by deducting payments and credits made during the billing cycle from the outstanding balance at the beginning of the billing cycle.
Previous balance method
This is based on the outstanding balance at the beginning of the billing cycle. Credit card companies make money when you don’t pay your bills in full each month.
Avoid credit card traps
- Make more than minimum payments. When you only make the minimum payments, you are paying more in interest charges and it will take you much longer to pay off your debts.
- Don’t skip payments. Many people skip payments before or after the December holiday season, in addition to using their credit cards to buy presents. Just remember that interest charges still continue when you don’t make monthly payments. You may also be charged a late fee, from $15 to $25.
- Don’t take cash advances. There is no grace period when you get a cash advance with your credit card. Interest charges begin to accrue on the advance immediately, and continue until your entire outstanding balance is paid in full. This is because there is no way to tell when the amount of the cash advance is repaid if there is always a balance due on your card. There may also be a cash advance fee that is based on the amount of the advance.
- Beware of credit card insurance offers. Credit card insurance costs range from $15 to $49, yet this insurance only covers the first $50 of any unauthorized charges from lost or stolen credit cards. And federal law limits your liability for unauthorized use of your credit card to only $50 anyway. In other words, if a thief uses your card to buy goods or services, you are only responsible for repaying $50 per card used.
- Beware of credit repair schemes. If you have a poor credit history, no one can repair it for you. Any corrective measures that someone claims they can take, you can do yourself at almost no cost. Don’t fall for this trap.
Some decisions to make about credit
- Decide to live within your means—don’t spend more than you make.
Deciding to adjust your needs and wants is a key part of this decision. - Set a limit on how much debt you will carry.
- Keep an eye on fees, annual percentage rates and grace periods.
- Keep track of your credit history.
It’s YOUR credit
Monitor your credit history
No one will have a greater interest in the accuracy of your credit files than you. By taking a look at the information in your credit file periodically, you can correct any mistakes. At the very least, check your credit history before applying for a major loan. If there is information in your file that is incorrect, you have a right to ask that it be removed.
You have a right to know what’s in your report, although there may be a charge for a copy of your report. Contact one of the three major credit bureaus:
Equifax Credit Information Services, Inc
PO Box 740241
Atlanta, GA 30374
(800) 685-1111
www.equifax.com
TransUnion
2 Baldwin Place, PO Box 1000
Chester, PA 190221
800-888-4213
www.transunion.com
Experian
701 Experian Parkway
Allen, TX 75013
888-397 3742
www.experian.com
Know your credit rights and responsibilities
There are a number of federal laws that protect your credit rights. You need to know what they are and use them as necessary. The Truth in Lending Act limits cardholders’ liability for lost or stolen credit cards. When a thief uses your card, their use is known as unauthorized use. If a stolen card is used, you are only responsible for the first $50 of unauthorized charges. But be careful: if you lose a wallet with five credit cards, and a thief charges several hundred dollars on each one, you are responsible for $250 in unauthorized charges. This is a good reason to limit the number of credit cards you hold.
The Fair Credit Reporting Act (FCRA), enforced by the Federal Trade Commission, is designed to promote accuracy and ensure the privacy of the information used in consumer reports. Credit bureaus and other consumer reporting agencies (CRAs), as well as businesses that supply information about you to CRAs, have legal responsibilities. For a copy of the Fair Credit Reporting Act and other information on consumer issues, visit www.ftc.gov or call toll-free, 1-877-FTC-HELP (1-877-382-4357).
Know the fees for your card
Issuers of credit cards have devised a number of fees. Although some of these fees might have been established to discourage certain behavior (like late payments), all of these fees can make money for the issuer.
Annual fee: this is a yearly fee for having the credit card. You pay this fee whether or not you use the card. Fees can range from zero to $55 or more. Some issuers offer no-annual-fee cards. Read the fine print. Some companies will waive the annual fee for the first year to get you to accept their offer.
Over-the-limit fee: a fee assessed for exceeding your credit limit. With credit cards, you have a credit line up to a certain number of dollars. If your charges go over that limit, you may be charged an additional fee.
Late fee: a charge that is assessed if your monthly payment is received past the due date.
Cash advance fee: a fee that is charged whenever you get a cash advance using your credit card. If you get cash from a bank or ATM using your credit card, the money you get is called a cash advance. Credit card issuers may charge a higher interest rate on cash advances than they do on purchases. Read the fine print.
Transaction fee: a fee charged each time a credit card is used.
Keep your credit cards in a safe place
Having one multipurpose card can help you monitor use, keep track of charges, and greatly reduce your cost if your card is lost or stolen (for example, $50 instead of $250). Make sure cashiers return credit cards and your copy of any receipts.
Know your credit picture
The charts below will give you a summary of your use of credit: the types, amount owed and monthly payments, as well as a list of credit cards you are using.
In the event of loss, theft or unauthorized use of a credit card, notify the card issuer immediately, since you may be liable for up to $50 on each credit card. It is important to have a list of your credit card numbers, and the name, address and phone number of whom to contact. It is best to have two copies of this list, one in your home file and another in a safe place, such as a safety deposit box or home safe.
Sources
10 Ways to Reduce Debt consumer credit curriculum. University Park, PA: Department of Agricultural and Extension Education, The Pennsylvania State University.
Banking and Personal Money Management. State of Maine Bureau of Banking, 1997.
McKenna, J. and C. Makela. Credit: Getting Started and Staying on Track. Colorado State University Cooperative Extension, 2003.
Jones, Joyce E. Basic Money Management curriculum. Kansas State University Agricultural Experiment Station and Cooperative Extension Service, 2001.
Your Use of Consumer Credit. Kansas State University Agricultural Experiment Station and Cooperative Extension Service
Know Your Credit Limits. The University of Georgia Cooperative Extension Service.
The Federal Reserve Bank. New York, NY.
Credit charts developed by Joyce E. Jones, Kansas State University Agricultural Experiment Station and Cooperative Extension Service.
| Current Credit Obligations | ||||
| Type/Purpose of credit | Amount still owed | APR* | Months left to pay** | Monthly payment |
| *Annual percentage rate
**Or date payment is due for single payment loans Total still owed:___________________ Total monthly payments_____________________ |
||||
| Credit Card Report | |||
| Type of card | Credit card number | Company/Institution | Address/telephone number |
Information in this publication is provided purely for educational purposes. No responsibility is assumed for any problems associated with the use of products or services mentioned. No endorsement of products or companies is intended, nor is criticism of unnamed products or companies implied.
© 2005
Published and distributed in furtherance of Acts of Congress of May 8 and June 30, 1914, by the University of Maine Cooperative Extension, the Land Grant University of the state of Maine and the U.S. Department of Agriculture cooperating. Cooperative Extension and other agencies of the U.S.D.A. provide equal opportunities in programs and employment.
Call 800-287-0274 or TDD 800-287-8957 (in Maine), or 207-581-3188, for information on publications and program offerings from University of Maine Cooperative Extension, or visit extension.umaine.edu.
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