Credit & loans — Credit offers money management flexibility

For most people, debt will play an important role in their financial life. Credit, which allows you to buy something now with the promise of paying it off later, gives you the flexibility to purchase big ticket items like homes, cars, and appliances. The key is to use credit responsibly, so the debt you take on doesn’t swamp your income and your budget.

Taking out a loan

All credit is some form of a loan. You borrow money for a period of time and agree to pay it back with a certain amount of interest added on top. There are different types of loans depending on how the terms and conditions are set up.

• Secured and unsecured — With a secured loan, something of value—such as a home or car—is put up as security for the loan. If loan repayments are not made, the lender can take possession of the secured asset. With an unsecured loan, a lender provides money trusting that the borrower can and will pay it back. If a borrower defaults on an unsecured loan, the lender may have more difficulty collecting the money. Since there is an asset guaranteeing a secured loan, interest rates for secured loans may be lower than those for unsecured loans.
• Installment loans — Think mortgages and car loans. You’re borrowing a specific sum for a specific purpose for a specific period of time. You agree to make fixed monthly payments at a certain interest rate until the loan is paid off. Often, you can pay the loan off early (and save some interest costs) by making larger payments. These are secured loans.
• Credit cards — This is an unsecured loan with more flexible terms. The credit card company gives you a maximum borrowing amount, your credit line, and you can borrow any amount in any size up to that maximum. If you pay back your charges by a certain deadline each month, you don’t have to pay any interest. If you choose to string out your repayments, you’ll be charged interest until you pay everything back in full. Because it’s so easy to borrow money with credit cards, some people overspend and take on more debt than they can handle. This can sabotage a financial plan.

It pays to know the score

When you need to apply for credit, your credit score provides a prediction of how likely it is you will pay your bills. The FICO score, a scale that runs from 300 to 850, is one of the more popular credit scoring methods.

Having a high FICO score is important. Your score determines whether you are approved for a loan and how high your interest rate will be. For example, the difference in interest rates offered to a person with a 620 FICO score and a person with a 720 score is 1.589 percent, according to Fair Isaac Corp., the developer of the FICO method. On a 30-year mortgage, that difference could cost more than $79,098 in extra interest charges on a $250,000 loan¹.

You can get and keep a high score by paying your bills on time, maintaining a few credit cards and installment loans but keeping balances low, and successfully managing your credit continuously over time.

Borrow wisely

Credit is an important part of our economy. Without it, most people would not be able to buy a home or a car or manage their day-to-day cash flow. Work it into your budget so you can track your debts and keep them under control. The one thing you can’t borrow to afford is retirement.

1. My FICO, loan savings calculator