Credit & Debt
Understanding credit and debt is crucial for maintaining financial health. Credit represents borrowed money that you can use to purchase goods and services when you need them. Debt is the result of using credit. While credit can be a useful financial tool, managing debt responsibly is essential to avoid financial strain.
Understanding Credit Scores
A credit score is a three-digit number that represents your creditworthiness. Lenders use this score to evaluate the risk of lending money to you. The most commonly used credit score is the FICO score, which ranges from 300 to 850.
Factors That Affect Your Credit Score
Payment History (35%)
Whether you've paid past credit accounts on time
Amounts Owed (30%)
The total amount of credit and loans you're using compared to your total credit limit
Length of Credit History (15%)
How long you've been using credit
New Credit (10%)
Recently opened accounts and credit inquiries
Credit Mix (10%)
The variety of credit accounts you have (credit cards, retail accounts, installment loans, etc.)
Interest Rates: The Cost of Borrowing
Interest is the cost of borrowing money, typically expressed as an annual percentage rate (APR). Understanding how interest works is essential for evaluating the true cost of loans and credit cards.
Simple Interest
Simple interest is calculated only on the initial principal amount.
Formula: Interest = Principal × Rate × Time
Example: $1,000 loan at 5% for 1 year = $50 in interest
Compound Interest
Compound interest is calculated on the initial principal and also on the accumulated interest over previous periods.
Formula: A = P(1 + r)^t
Where A is final amount, P is principal, r is rate, and t is time
Example: $1,000 at 5% compounded annually for 5 years = $1,276.28
Types of Debt
Student Loans
Student loans are specifically designed to help students pay for higher education expenses, including tuition, books, supplies, and living expenses. They generally have lower interest rates compared to other types of loans and offer flexible repayment options.
Key Features:
- Federal and private options available
- Fixed or variable interest rates
- Grace periods before repayment begins
- Income-driven repayment plans (for federal loans)
- Potential loan forgiveness programs
Credit Cards
Credit cards provide a revolving line of credit that can be used for purchases. While they offer convenience and potential rewards, they typically have higher interest rates compared to other forms of debt.
Key Features:
- Revolving credit line
- Minimum monthly payments
- High interest rates (often 15-25% APR)
- Grace periods for purchases if you pay in full
- Potential rewards and benefits
Pro Tip: Pay your balance in full each month to avoid interest charges. If you can't pay in full, pay as much as possible above the minimum payment.
Mortgages
A mortgage is a loan used to purchase real estate. It's secured by the property itself, which means if you fail to repay the loan, the lender can take possession of the property through foreclosure.
Key Features:
- Long repayment terms (typically 15-30 years)
- Fixed or adjustable interest rates
- Required down payment (typically 3-20%)
- Tax-deductible interest (in many cases)
- Additional costs like property taxes, insurance, and possibly PMI
