Understanding Credit

Everyone needs to start somewhere. If you’re new to credit or looking to rebuild your score, it can be tough to understand what all the terms mean and how to decide what’s the best fit for your situation. Credit Scores and Loans can seem scary, but they don’t have to be! Let’s start by explaining some basic terms.

Loan:

Simply put, a loan is when a lender (usually a bank or credit union) allows you to borrow (get funds up front) a specific amount of money. You promise to repay that money, with interest, over a set amount of time, usually with fixed monthly payments. Let’s unpack that a little:

Let’s say you borrow $1200 at a 10% APR (Annual Percentage Rate, more commonly known as the interest rate). The loan term (how long you have to pay it back) is 12 months. At first glance, the payment (the amount you agree to pay each month) might seem like it should be $100 per month, but that doesn’t account for interest. Once you factor that in, your payment is actually around $106 per month. Of that, $100 is going to principle (the amount you borrowed) and $6 is going to the interest charges. Over the course of the year, if you make every payment as scheduled, you will have paid approximately $66 in interest for the opportunity to borrow that $1000.

There a few different kinds of common loans:

Unsecured Loans:

Basically, these are loans where the lender agrees to let you borrow funds based on your credit score, repayment history, debt load, income, or other factors, but which do not have collateral attached. Personal Loans and Credit Cards are the most common types of unsecured loans.

Secured Loan:

These are loans which use something of value, usually your home or your car, as collateral against the loan. So, for instance, if you take out a car loan, your vehicle actually acts as security for the lender. If for some reason you stop making payments, the lender has the right to take and sell that property to help cover the unpaid balance. Because this type of loan has that extra layer of security that the loan will be paid, rates are typically lower than on an unsecured loan.

Credit Card:

Like we mentioned, a credit card is a kind of unsecured loan, but it works a little differently. With a credit card, you can borrow as much as you want at any time, up to your credit limit. Your monthly payment isn’t a fixed amount, like with a regular loan. Instead, a credit card is considered an ‘open ended loan’, and the amount you pay monthly changes depending on your balance.

You will always have a ‘minimum payment’ each month, typically about 2% of the balance. Some of this will go to the interest charges for the month, and some will go to principle. Be careful! It’s tempting to just assume the ‘minimum payment’ is all you need to pay – while it’s true that will count as ‘paying as agreed’, if you only make the minimum payment it can take years to pay off your purchases. Whenever possible, you should always pay more than the minimum each month.
Interest on credit cards accrues daily, and some types of transactions, including balance transfers and cash advances, begin accruing interest the day you make them.
Want to have the convenience of using a credit card without having to pay interest? There’s a way to do that. It’s called ‘paying in full’, and it means that each month, you make the full payment for the statement balance. Basically, this means that if you charge $500 in a statement period, when you get the bill, instead of just paying the minimum or any amount under that $500, you pay the entire amount that you borrowed during that statement cycle. If you do this consistently each month, you will avoid interest charges. It’s important to note that this only works if you use your card for purchases – balance transfers and cash advances will always accrue interest daily regardless of whether you may them off in full each month.