What is credit? Credit has become such a large part of everyday finances that it can sometimes be easy to forget it’s not just the same thing as cash. Where adults from generations past could hardly think about purchasing something if they didn’t have the money upfront, nowadays using credit to make a purchase almost seems like everyone’s default position.
But is that a good thing? And what do those “buy now, pay later” purchases do to your overall financial health, as well as the perception of your financial health? Let’s find out.
What is Credit — And What’s the Catch?
Okay, there’s a good chance you already know pretty well what credit is. It’s essentially the ability to buy something without having to pay for it up front because a lender trusts that you’ll pay eventually. However, have you ever stopped to think about why so many companies are willing to lend you money in advance and what the catch might be for you?
Credit comes in many forms these days. You can get a personal loan, a line of credit (such as your credit card), or a direct loan. Your loan or line of credit might have collateral or not (collateral being a physical belonging you forfeit if you default on the credit — such as a home or car). And you can get the credit from a bank or credit card company or even from a company selling you goods.
However, no matter what form you get credit in, it almost always comes with one catch: Interest. Interest is when the issuer charges you a percentage of what you’ve borrowed each month to hold a balance on that credit account. It’s the reason companies are willing to lend you money — because, on average, they’ll make their money back and then some.
The High Cost of a Low Credit Score
As you might have already noticed, interest rates can vary quite a bit. That’s because the level of interest you pay is directly proportional to the level of risk a lender thinks they’re taking on you. So if you have a history of poor credit behavior (accounts in default, late payments), you’re going to pay a higher interest rate.
This is just one more reason why it’s so important to work on your credit score. The better your credit score, the safer a bet you’ll seem to lenders and the less you’ll pay in interest on your purchases made with credit.
Let’s look at an example. Say your car has bitten the dust unexpectedly. You haven’t been planning for a new (or used) car purchase and you haven’t checked your credit in awhile. What might you expect to pay in interest?
According to recent data from ValuePenguin, someone with a FICO® score of 720 and above might be approved with an interest rate of 3.60%. For someone with a low credit score, say 589 and below? ValuePenguin shows they might pay 15.24%. Here’s what that might look like on a five-year auto loan for a $30,000 car, using a calculator from Cars.com:
- The person paying 3.60% in interest on a $30,000 car with no down payment will pay $547 per month (excluding sales tax).
- The person paying 15.24% in interest on the same car without a down payment will pay $717 per month.
- Over the life of the loan, the person with the highest credit score will pay $32,820 for their car, while the person with the lowest credit score will pay $43,020. In other words, having a low credit score will cost that person an additional $10,200 from what the person with the lowest score would pay.
And if your low credit takes you out of the running from approval on a new car, forcing you to go to a bad credit car dealership, you might be paying all that extra money on a car that also needs frequent repairs.
What’s more, this is just for a five-year auto loan. It doesn’t take a calculator to imagine the implications a lower credit score might have on someone who’s looking for a home on a 30-year mortgage.
FREE TOOL: Are mistakes on your credit report hurting your credit score? Find out here.
Beware the Payments Puzzle
Whether your credit is stellar or needs some work, you’re almost always going to pay something extra for your purchases if you use credit. The only time that isn’t true is if you pay off the purchase before interest accrues — such as if you pay off a credit card each month before the due date or if you receive a promotional financing of 0% for some months on a loan or line of credit.
But interest isn’t the only catch of credit — it’s also important to not get trapped in the payments puzzle.
Let’s go back to the car buying example. You might walk into a dealership with a certain price in mind when all of a sudden the dealer runs your credit and says you can afford an even better car. Exciting, right?
What they’re doing in this situation is trying to get you to focus on your monthly payment instead of the overall price of a car. And by either discovering that you can be approved for a low interest rate or by extending the timeline of the loan, suddenly it might seem like the payments on a more expensive car are actually “in your budget.”
But they’re often not, really. Yes, you might be able to work that higher payment into your monthly budget — but that doesn’t mean the more expensive car is in your overall budget. That’s why it’s important to understand the cost of the item over the life of the loan.
Use the calculator above to do the math yourself. If you walked in expecting to buy a $30,000 car and you walk out with a $35,000 car just because you can afford the payments, you’re still going over your budget before you even factor in the cost of several years of interest payments.
This happens in real estate as well. Given the fact that many mortgages are set up for repayment over 30 years, it’s easy to increase a home buying budget without having a massive effect on your monthly payments. But you’ll still be paying much more than you intended, both by going over your initial budget and by paying interest on that higher price every month for 30 years straight.
Stick to your budget by deflecting the payments game. If someone trying to sell you a product shows you how you can “afford” a higher price, do the math on the overall price including interest over the length of the loan before you sign. Then you’ll be able to walk into your credit purchase with your eyes wide open.
Credit: A Great Tool When Used Wisely
The popularity of using credit for purchases, and the ease with which consumers can do so, is still a relatively new phenomenon. Still, there needs to be some strategy involved to make sure usage of credit doesn’t turn into overwhelming debt. Follow the steps above to help make sure you’re in control of your credit.