Overview of Credit
What is the difference between credit and a loan?
Credit is the ability to borrow money now and pay it back later. When you borrow money on credit, you get a loan. You promise the lender that you will pay back the money you borrowed – plus interest – on a set schedule, perhaps monthly. Interest is your cost to borrow money. There are several terms you will need to understand when it comes to credit:
- Credit – The ability to borrow money now, and pay it back at a later time.
- Loan – Money that you borrow from a lender and promise to pay back on a set schedule.
- Interest – When you borrow money, you may a promise to pay back the money you borrowed plus some extra. The extra amount is called interest. Interest is your cost to borrow the money.
You have probably heard the term “good credit.” Having good credit means that you are careful how you manage credit – for example, you make your loan payments on time.
If you have a good credit record, it will be easier to borrow money in the future. If you do not use credit responsibly, it will be harder and more costly to borrow money in the future.
Before borrowing money, make sure the loan payments fit into your spending plan. In other words, can you afford to repay the debt?
Why is Credit Important?
Credit is important because it:
- Can be useful in times of emergencies.
- Is more convenient than carrying large amounts of cash.
- Allows you to make a large purchase, such as a car or house, and pay for it over time.
- Is the record of how you manage your credit and may affect your ability to obtain employment, housing, and insurance.
Collateral and Guarantees
When a financial institution agrees to lend you money, they may want some assurance that you will pay them back. A loan is often secured by collateral or a guarantee.
Collateral is something you provide the lender to secure a loan.
Example: You pledge an asset you own, such as your car, to the lender to secure the loan. If you do not repay the loan, the lender can take the asset and sell it to help repay your loan.
Guarantee is a form of collateral.
Example: Co-signing is a form of guaranteeing a loan. For instance, a person with no credit history may ask someone else to co-sign a loan. The co-signer is then equally responsible for the loan. The co-signer must pay the unpaid loan balance plus interest if the borrower does not repay the loan as agreed.
Secured vs. Unsecured Loans
Sometimes a lender will require collateral. Loans that require collateral are referred to as secured loans. Common examples include loans to purchase a car or home. In a secured loan, the borrow pledges (gives) collateral to the lender for the loan.
Loans that do not require collateral are called unsecured loans. Examples include most credit cards or student loans. An unsecured loan is not backed by collateral.
Assets are the items you own that can be used to secure loans. An asset is something valuable that you own, like a car, savings accounts, and property such as your home.
Some items generally cannot be used as collateral, unless they are used to secure the purchase of that item itself. These include:
- Furniture for your home
There are several different types of loans:
- Consumer Installment Loans
- Credit Cards
- Home Loans
Consumer Installment Loans
With a consumer installment loan, you borrow a fixed sum of money and agree to pay it back to the lender by making equal loan payments over time.
A consumer installment loan is used to pay for purchases and other expenses for you and your family.
An example includes an auto loan. The automobile you are purchasing is used as collateral for the loan. With a consumer installment loan, you are borrowing a fixed sum of money. You pay it back with equal payments over time.
Credit cards are another type of loan. Credit cards are examples of open-end credit. This means the lender agrees to lend you up to a certain sum of money, known as your credit limit. You make payments based on how much credit you have borrowed. Once you repay the money you borrowed, you can borrow it again – up to your credit limit.
Credit cards give you the ongoing ability to borrow money for household, family, and other personal expenses. Having a credit card allows you to buy things and pay for them later.
Remember that if you are not careful in spending, you can get into big trouble – you could be burdened with credit card debt. You need to be sure you are able to make the minimum monthly payment on your credit card bill.
The three main types of home loans are:
- Home purchase
- Home refinancing
- Home Equity
A home loan is made for the purpose of buying a home. It is secured by the home you are buying. That means you could lose your house if you do not repay your loan as agreed.
This type of loan replaces an existing home loan by paying it in full and replacing it with a new home loan. A cash-out refinance loan allows you to borrow more money than is owed on the loan being replaced. Homeowners often refinance their home loans to obtain a lower interest rate, to get money for home repairs, or for other personal needs such as investments.
Equity is the current market value of your home minus what you owe (your mortgage loan balance) for the house. A lender may allow you to borrow up to a certain percentage of your home’s value, generally up to 80 percent.
Home equity loans allow you to borrow money that is secured by your home. There are two main types:
- A home equity loan can be a one-time loan for a lump sum, typically at a fixed interest rate. These loans are sometimes called home improvement loans.
- A home equity line of credit works like a credit card in that you can borrow as much as you want up to a pre-set credit limit. The interest rate for a line of credit is usually variable, meaning it could increase or decrease in the future.
Fees & Interest
Borrowing money is not free. When you get a loan, there are generally two costs you must pay: fees and interest.
Fees may be charged by financial institutions for activities such as reviewing your loan application. They may also charge you a penalty fee if you violate the terms of the loan agreement. For example, a lender might charge a $30 late fee when you do not pay your bill on time.
The lender might also charge other fees. For instance, a credit card company might charge you an annual maintenance fee or a service fee when you get a cash advance.
An important thing to remember if you borrow money is that borrowing usually involves a cost called “interest,” which is the fee to compensate the bank or other lender when you use their money. This is the reverse of what happens when the bank pays you interest to put your money in the bank.
Interest is the amount of money a financial institution charges for letting you use its money. The interest rate can either be fixed or variable.
Fixed rate loans generally stay the same throughout the term of the loan.
Variable rate loans might change during the loan term. The loan agreement will show the details of the rate changes.