Borrowing money makes it possible to afford things that you couldn’t otherwise, but take time to understand what you’re signing up for in order to stay on top of payments as well any benefits your credit offers.
Paying it Back
Let’s be clear right from the beginning: when you pay for something with credit, you’re still on the hook for that money. Often, if you don't pay your statement in full each month, you’ll need to pay back more because of interest. The type of credit you use and the specifics of the agreement will determine how much interest you’ll have to pay, the size and frequency of your payments, and more.
It’s extremely important to recognize that credit, if you're not monitoring your use or monthly bills, can become overwhelming. If you borrow too much or at too high of an interest rate, you can end up owing more than something is worth or being in a position where you’re struggling to pay back everything you borrowed.
3 Types of Credit
There are three types of credit that you’ll interact with most often:
Revolving credit is a type of credit where you can borrow, pay off, and borrow again up to a pre-defined amount of money. At regular intervals (usually a month), you’ll need to pay back at least a minimum amount. If you don’t pay off what you borrowed completely by that time, the unpaid amount will carry over to the next billing cycle and begin accruing interest. The most common examples of revolving credit are credit cards, HELOCs, and other lines of credit.
Installment credit is a type of credit where you borrow an amount of money all at once and pay it back in predetermined chunks or installments. These regular payments could last for only a few months or multiple years. Almost all loans are examples of installment credit, so that would include car loans, mortgages, or student loans.
Open Credit is the final type of credit, and one that you may not even think of as credit. This is when you use something and then pay for it afterward in regular intervals. The most common examples of open credit are bills, like for your cell phone or utilities. You use the service on credit and then pay for what you used on your next bill. These types of bills don’t usually charge interest but will add fees if the amount isn’t paid on time or in full.
Rules for Using Credit
These rules can help keep you on top of your borrowing and avoiding dings to your credit score:
- Always try to pay off your credit card in full so that you can avoid paying interest. And, don't forget to use your credit card rewards, such as cash back which could assist you paying down your bill.
- Pay more than your minimum on loan payments so that you pay it off faster and pay less in interest (but be aware, there are some loans out there that have early payoff penalties).
- Keep your debt to income ratio (DTI) below 28%. To find your current DTI, add up how much you pay each month in debt payments and divide it by your gross monthly income.
- Avoid borrowing too much at once. It’s best to keep your credit utilization ratio, or the ratio of how much you borrow versus how much you’re approved for, under 30%. So, if your credit card has a $10,000 limit, it’s best to keep your carried balance under $3,000.
- Try to pay the standard 20% down when buying large items like a house or car. The higher the down payment, the more you own of the item. This means you won’t have to borrow as much and you’re less likely to end up owing more than it’s worth if the market changes drastically.
How you use credit will have a big impact on your life. Good credit—where you use credit wisely and follow the steps above—can allow you to buy things you couldn’t get otherwise. Bad credit—where you spend more than you can afford to pay back—will affect your ability to borrow in the future. Learn more about factors affecting your credit score here.
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This article has been republished with permission. View the original article: Using Credit.