You’d have a hard time finding someone who hasn’t had a loan or a credit card at one point or another. But despite how popular it is to borrow money, many people don’t understand much about their financing options. Unfortunately, financial advice is often overlooked by high schools and colleges.
Loans and credit are simple enough to understand, and it’s important to know how they work. Even if you don’t know a thing about the subject, this beginner’s guide will get you up to speed.
Loans and Credit – What’s the Difference?
With loans and credit, you’re borrowing money, but the two work very differently.
When you get a loan, the lender gives you a lump sum of money upfront. You then pay that amount, plus interest and other charges, back over the lifespan of the loan, which is known as the term. For example, on a loan with a five-year term, you would make payments every month for five years. Payments are often amortized, which means each payment is the same amount. If the final payment is much larger than the ones before it, then it’s called a balloon payment.
With a credit card or a line of credit, the lender sets a credit limit for you. You’re then able to borrow money up to that amount. Unlike a loan, there is no set time period to pay this money back. Instead, you must make at least your minimum payment every month. You can borrow more money whenever you have available credit. Although credit cards are the most common type of credit, there are other options available.
Secured and Unsecured
You can break loans and credit down into two categories – secured and unsecured. It all depends on whether the loan or credit has a piece of your property attached to it as collateral. If so, it’s secured. If it’s only backed by your personal guarantee, it’s unsecured.
If you use the loan or credit to purchase something, then that may be the collateral on it. Take a mortgage as an example. You use it to buy a home, and that home serves as the collateral to secure the loan.
Credit cards are typically unsecured, although there are secured credit cards available which require a cash deposit. These are intended for people who are establishing or building their credit.
Paying Back Loans and Credit
Any time you borrow money, you’ll make payments, and your payments will have a due date. It’s important to make your payments on time, because if you don’t, you could get charged late fees. It can also cause your credit score to go down. Your credit score is a measurement of how creditworthy you are based on your financial behaviors in the past.
You usually need to start making your payments shortly after you borrow money. If you borrow a loan, you’ll start paying on it the month after you receive the loan money. If you pay for something on credit, your payment will be due a certain period of time after it hits your statement.
The exception to this is student loans. Because these are designed for college students to use in paying for their education, lenders usually don’t require payments for a few years. This gives the student time to finish school before they’re responsible for paying back a loan.
When you use loans and credit the right way, they can be valuable financial tools. The problem is that many people use them irresponsibly, especially credit cards. The average consumer ends up with thousands of dollars in credit card debt. Since credit cards only require a small minimum payment, it’s easy to overspend and not pay enough back.
How can you avoid these issues?
For loans, you should carefully read over the terms before applying and only get a loan when absolutely necessary to finance a smart purchase, such as a home or your education.
With credit cards, it’s best to look for a card that earns a good rewards or cashback rate. This way, you get a return on your spending. Pay it off in full every month, though, because the interest on credit cards can be a killer.