This post is part of the textbook personal finance series which covers basic personal finance skills by going through an actual textbook, chapter-by-chapter. Check out the intro post for more information.
Credit is a hot button in the personal finance world and in American society. Between the housing bubble (credit), the new credit card regulations, the failures of many banks and credit card companies, etc, credit as we took it before is being redefined. Some, far too many, are finding out that they never understood even the basics of consumer credit and had simply followed societal patterns…bad societal patterns.
So I’m glad that this week the textbook is starting a new section specifically on consumer credit (which they define to exclude a mortgage on the home you live in).
What Is Consumer Credit?
Let’s start with what credit is. Credit is an arrangement to receive cash, goods, or services now and pay for them in the future. It’s everything from credit cards to car loans to student loans (though sometimes they get classified outside consumer credit…depends if you consider a college education a product) to business loans to mortgages.
Consumer credit is the credit used by individuals and families to buy goods. This is in contrast to business credit used to start or fund companies or to invest in things like rental homes.
Consumer credit dates far back. It could be everything from taking out a loan from a bank (which used to be reserved for the already-affluent) to buying groceries and paying for them at the end of the month. However in America, credit has become widely-used by rich and poor alike.
There are a number of advantages to using credit, normally involving meeting a need that is better filled now than later. Student loans are often looked at as practical because it’s generally expected that your earning power will significantly increase once you’ve gone to college—therefore it’s better to pay for it retroactively than work for years for less and save up.
Unfortunately, having access to credit tempts many to overspend, whether in taking out loans for more than they should (e.g. huge student loans when their field doesn’t have a large expected salary) or in building up credit card debt they don’t pay off. Credit always costs money (except if you pay off the entire balance on your credit card each month).
Credit is only truly useful when you don’t pay interest on it (because you pay it off before the interest accrues) or when you really do need to pay interest to borrow the money.
What is Closed-End Credit?
Closed-end credit is a specified amount, generally for a specified purpose. Any kind of loans that are paid off in installments are closed-end. These include car loans, student loans, (mortgages), and any kind of purchases made in “6 easy payments of $150.”
There are three types of closed-end credit: installment sales credit, installment cash credit, and single lump-sum credit.
Installment sales credit is a loan that allows you to receive merchandise now and pay for it in installments. This is how many people buy large appliances and electronics, it’s also called “store financing.”
Installment cash credit is a direct loan of cash for personal purposes such as home improvements, vacations, or making large purchases (like getting a loan from a bank to pay for your car, rather than getting sales credit from the dealer).
Single lump-sum credit is a loan that must be repaid at once on a single day. Payday loans and pawn shop loans function this way, but so do some legitimate smaller loans.
What is Open-End or Revolving Credit?
Open-end credit has a limit but is not for any fixed sum or period. Credit cards are the most common examples of open-end credit. A credit card company or bank extends a line of credit (the total amount available to be borrowed) and then you spend as much or as little of that as you like and pay interest accordingly.
In many cases, you don’t have to pay any interest as long as you pay it off within the grace period. If you don’t pay off the entire line of credit, you’re required to make minimum payments of part of the amount owed + interest. The rest will accrue interest and roll over into the next month.
Another form of revolving credit which became popular in recent years was the “Home Equity Line of Credit” or HELOC. In this case, you take out what is essentially a second mortgage that functions like a line of credit. You can borrow up to the limit and pay back all at once or just make installments.
The biggest difference between a HELOC and a regular line of credit is that a HELOC is secured by your home. If you don’t pay off a credit card, you could end up in court and all kinds of trouble. If you don’t pay off a HELOC, you could be forced to sell your house to repay the debt.
I’m skipping over the section on sources of loans, which is a bit out of date. Next week we’ll look at the 5 Cs of Credit.