Understanding Credit Tutorial

What is Credit?

Credit can be very valuable to your financial tool box if used carefully and sensibly.  Credit means someone is willing to loan you money called principal in exchange for your promise to repay it, usually with interest.  Interest is the amount you pay to use someone elses money.  So the higher the interest rate, the higher the total amount you pay to buy something on credit.

How to Build Good Credit

Having good credit makes it more likely that you will be able to get a loan in the future when you want to make a major purchase like a car or home.

  • Always pay your bills on time.  Thats the best way you can show creditors that you’ll be responsible with their money.
  • If you have a savings account, its good to make additional regular deposits, no matter how small.  Lenders like to see a consistent savings pattern.
  • Pay off your credit cards in full each month.  If you don’t then you will carry a balance and you will have to pay interest on that balance. If you plan to carry a balance you should look for a card with the lowest annual percentage rate.
  • Surprisingly, its better for your credit score to maintain a low balance on one card and pay it off each month than to have no balance at all.

What is a Credit Card and How Do They Work?

Credit cards are a convenient form of borrowing and are great tools to help you build your credit history. People generally use credit cards to purchase goods and services. They are considered an open-end loan rather than a closed-end loan, because there is no set term for repayment. Credit cards have a revolving line of credit, which means you can make an unlimited number of purchases, up to a pre-approved dollar limit. The limit might be $500, $1,000, $3,000, or much more. You must pay at least a part of the bill every month. This is called a minimum payment. It is often a certain percentage of your balance.

Most credit cards are unsecured. This means you do not have to provide collateral in order to get a credit card. Collateral is what you promise to give the financial institution if you do not repay a loan. Examples of items that can be used as collateral include cars, homes, or savings accounts.

You might want to consider a secured credit card if you have no credit history or have had credit problems in the past. To get a secured card, you need to pledge a savings account as collateral. This means the credit union holds the savings account as security for repayment. For example, if you want a credit card with a $500 limit, the credit union will require you to keep $500 in your savings account. You will not be able to withdraw, or take money out from that account. The credit union can use that $500 if you are unable to pay your credit card bill.

Credit Report

A credit report is a record of how you have paid your debts.  Borrowers with low scores on their credit report may be turned down for credit or will pay a higher interest rate than borrowers with high scores.

A credit report tells creditors:

  • Who you are, your name, address, SSN, and phone
  • How much you owe other people and if you’ve made your payments on time, how long you’ve had them, and how much of your credit limit is unused.
  • Whether there is negative information about you in public records, such as collection actions, bankruptcies, and/or judgments.  Inquiries listed in your credit report. This report lists the credit card companies and other authorized companies that have requested and received your credit report. It tells creditors how often you apply for credit. Applying for new credit too frequently may be a signal to creditors that you are a higher credit risk.

Free Credit Report Once a Year

The Fair Credit Reporting Act requires each of the three credit reporting agencies to provide you with a free copy of your credit report, at your request, once every 12 months. Visit www.annualcreditreport.com.

Credit Terms

Annual Percentage Rate (APR) – The interest you’d pay on a purchase over a year.  It is stated as yearly percentage rate. If you plan to keep a balance on your credit card account, you want to look for a low APR. Then you will pay the least possible interest. If you expect to pay your credit card bill in full each month, it is more important to focus on the annual fee and other charges.

Annual Fee – A yearly charge you pay for the privilege of using the credit card.

Credit Limit – The maximum amount of credit a lender will give you.

Finance Charge – Seen on your credit card statements, and it represents the actual dollar cost of using credit to maintain a balance.

Grace Period – The time during which the card issuer doesn’t charge interest on the purchase.