How Should I Use Credit in My Financial Plan?
Borrowing money to make major purchases such as a house, car, or furniture is relatively simple in our economy. However, in addition to the purchase price of an item, there are additional expenses incurred by financing or using credit to make a purchase.
What are the basics of credit?
There are many institutions such as banks, credit unions, credit card companies, and retailers that will allow you to borrow money to make major purchases. Every dollar that these institutions loan comes from someone who has contributed to that institution through a savings or an investment account.
When you take out a loan or finance a purchase from a bank, the face amount of the loan is the principal. Each month, you make a payment to repay the loan. This monthly payment consists of two parts the principal payment and the interest payment. The principal payment goes directly to pay down the loan, and reducing the outstanding balance. The interest payment is based on the interest rate charged by the financial institution. It is the amount of money that you pay in addition to the loan. The interest is how the institution gets compensated for the risk it takes in loaning you money to make your purchases. The interest amount is calculated against the outstanding balance.
For example, assume you borrow $10,000 from a credit union at 5% annual percentage rate (APR) with the promise to pay it back over the next 60 months. Your monthly payment would be $188.71, and the total of all payments made over 60 months would be $11,322.74. Of this amount, $1,322.74 was the interest charged by the credit union over the life of the loan. By using credit to finance the purchase, you paid over 13% more than you would have if cash was used for the original $10,000 purchase.
What is a credit score?
Financial institutions that lend money to consumers take on some risk in that the borrower may not repay the original loan according to the terms of the loan agreement. Thus, the financial institution takes on risk when loaning money. To help reduce the amount of risk associated with a consumer loan (mortgage, auto, credit card, etc.), the financial institutions look at the credit histories of their loan applicants. Individual borrowers with a history of financial reliability will have a better credit history and will be a lower risk.
There are three major bureaus that track an individual consumer’s credit history: Experian, Equifax, and Trans-Union. When you apply for a loan or credit, the financial institution will obtain your credit report and a consolidated credit score (also known as a FICO score) from one of these bureaus. The higher your score, the more financially reliable you are, and generally the financial institution will offer you better terms on your loan, such as a lower APR or a higher loan amount.
John Sledgianowski is an AAFMAA Benefits Advisor.