Chapter 5: How Credit Works

The practice of extending credit gives consumers purchasing power beyond their current financial resources. It enables one to access goods and services before they are fully paid for. Buying and selling on credit has been a cornerstone of commerce since the days when shells and cattle were accepted mediums of exchange.

Merchants have always found it advantageous to allow people to buy now and pay later. This feature increased sales and provided additional income from interest and fees. The practice also bolstered the economy by enabling forward motion. For centuries, farmers have purchased seeds and equipment with a “promise to pay” agreement at harvest time. Brick masons ran a tab for supplies in order to build homes. Even artisans were allowed the use of paint and canvasses in exchange for their vow to pay the bill when the masterpiece was sold.

From the standpoint of the consumer, being able to buy on credit is not only convenient; it has long been viewed as a sign of trustworthiness and financial success. An offer of a line of credit, approval for a mortgage or being issued a major credit card is regarded as an “accomplishment” or proof of one’s money management savvy.

Financing a project is not a dreadful concept. It does have its advantages. However, relying on unrealized resources can also pave the way to financial chaos for all concerned without adequate knowledge and preparation. It's important to understand how credit works.

The Cost of Credit

Interest in the lender-borrower scenario refers to the amount of money the lender charges for the use of money or the monetary equivalent in the case of an item such as a vehicle or a kitchen table. Interest is expressed as the Annual Percentage Rate, or APR. It indicates the yearly charge for the use of funds. If you have an APR of 15% then your monthly rate is 15/12 or 1.25%. Interest rates can range from a low of 2% to a high of 40%.

Some lenders advertise monthly interest rates that can be misleading. Be sure to do the math. A monthly interest rate of 3% is an annual rate of 36%! Also, check for promotional rate offers. Many companies offer no interest or very low interest only for a short amount of time to entice customers. You must know the terms and timelines.

It is also important to understand the balance that is used for determining interest and fees.

Some companies base your finance charge on your current balance. Others may tally your interest according to an average balance or the balance on record for the previous month. In addition to quoting the APR, all companies must state in writing the specific method used to calculate interest. Be aware that the lender retains the right to alter the terms of the agreement as long as they notify you in writing.

Interest rates can vary widely due to several factors. The account holder’s payment history has a tremendous impact on the interest rate. Late payments or payments below the minimum amount required can cause the interest rate to double within a month. Even late payments on other cards can cause a rate hike. When using credit cards, it is best to pay your balance in full each month to avoid additional interest charges.

Some financial institutions offer variable rate cards. The interest is linked to the prime rate. If the prime rate goes up, your rate will increase accordingly. If the prime rate goes down, you will notice a decrease in your interest rate. The company must give you written notice before making any rate changes.

The Grace Period

The grace period is another important feature of the cost of credit. The grace period is the no-interest period on your credit card. It is usually 25 days, however, some companies have shortened the time to 20 days. Again, read the fine print. The grace period allows you time to pay your bill in full without accruing finance fees. The grace period only applies to new charges. Some cards do not offer a grace period. This means that interest is applied at the time the charge is made. Most cards do not offer a grace period on cash advances, meaning that if you withdraw cash, the interest begins to accrue immediately. In most cases you will also be assessed a transaction fee when you get a cash advance.


When shopping for a loan, be sure to find out the method for calculating the finance charges. Interest on loans can be either simple or compounded. Simple interest is based only on the original amount borrowed. For example, if you borrow $5,000 to be paid back in four years and you are charged 5% simple interest you would calculate your interest according to the following method:

  • $5,000 x .05 = $250 x 4years = $1,000 total interest You would be paying back a total of $6,000 over the course of four years. The simple interest method is often used on loans between private parties. Financial institutions rarely use this method for calculating interest; most use what is known as the compound interest method. Compound interest is based on the original amount borrowed plus all accumulated interest. If you borrow the same $5,000 at 5% interest compounded annually for four years, your total repayment amount will be higher:
  • Year 1: $5,000 x .05 = 250 (250 + 5,000 = 5,250)
  • Year 2: $5,250 x .05 = 262.50 (262.50 + 5,250 = 5,512.50)
  • Year 3: $5,512.50 x .05 = 275.62 (275.62 + 5,512.50 = 5,788.12)
  • Year 4: $5,788.12 x .05 = 289.40 (289.40 + 5,788.12 = 6,077.52)

Total interest over the course of four years would be $1,077.52. Add that interest to the original loan of $5000 and you would end up paying back $6,077.52 over the course of four years.

The lender determines the compounding schedule. It can be annually, semi-annually, quarterly, monthly or daily. It is easy to see the value of compounding from the perspective of the lender. However, you will reap the benefit of the compounding principle when you invest your funds. If you are considering an investment, research the compounding schedule offered by various banks. Banks can offer the same interest rate but different compounding schedules. An investment with quarterly compounding will offer a higher return than the same amount of money compounded annually.

Types of Credit

There are several ways to finance your purchase if you wish to enjoy now and pay later. The revolving account and the installment plan are the most popular types. You may also get a loan or choose a rent-to-own option.

Secured and unsecured credit are terms that often cause confusion. A secured debt is one that involves collateral or property that the lender can repossess if you fail to adhere to the terms of the agreement. An unsecured debt does not have any property attached. The consumer is allowed to borrow money simply with the pledge that it will be repaid as agreed.

The Installment Plan

An installment plan is designed to be paid off through regular, equal payments or installments. Appliances, vehicles, furniture and other big ticket items are often purchased on an installment plan. A home mortgage is also a type of installment account. Sometimes you are required to pay a percentage of the purchase price up front as a down payment.

Once these requirements are met, you are allowed to take possession of the item while you pay off the balance. Any interest and fees are included in the monthly payment. The installment plan is also called a secured debt because the item purchased is the collateral for the debt. The item purchased is usually considered the security for the agreement. If it is repossessed, the item can then be sold by the company. If they do not fully recoup the cost of the item, you can be held responsible for the remaining balance.

The Revolving Account

A revolving account allows the account holder to bill charges to the account up to a certain amount. A minimum payment is required each month. This payment is based on the unpaid balance, which is usually 2% to 4% of the balance.

An account holder can continue to make purchases without paying the balance in full as long as the required minimum monthly payment is satisfied and the credit limit has not been exceeded. Of course, it is always best to pay your balance in full or pay at least more than the minimum due each month. The minimum payment is set to ensure that the credit card company makes the highest amount of interest from your purchases.

With a revolving account, any remaining balance and applicable interest transfers to the next billing period. Bank cards like Master Card, Visa and Discover are examples of revolving accounts, as are store and oil company cards.

Travel and Entertainment Cards

Some companies offer cards that are mainly used for travel and entertainment. American Express and Diners Club are two of the most popular. Consumers use them to charge hotel rooms, airline tickets and business expenses. The balance must be paid in full each month and there is usually a yearly membership fee.

Obtaining Credit

If you are considering applying for a loan or a credit card, it is important to take some preparatory steps. First, be sure that you have completed a budget and that you are aware of your current financial status. This will guarantee that you know how much you can comfortably borrow and repay, and it can help you calculate how much of a credit limit to request.

Next, determine what your needs are. Do you want to establish new credit? Do you have an urgent need like a car transmission on the fritz or a broken tooth? It is important that you are clear about the driving force behind your actions. It can be advantageous to have access to an item or service while you are paying for it, but it is wise to remember that you are incurring an additional responsibility. Payments must be made on time and within the guidelines of your agreement.

Finally, be sure to consider your temperament. Evaluate your capacity to be disciplined in your spending and to honor long-term commitments. In most cases, you will be obligated to your creditor for an extended period.

After you have completed your personal assessment, you are ready to evaluate your options. Be prepared to read each application thoroughly. In addition to interest, many companies charge extra fees for other items. Application, transaction, late, over-the-limit, membership and service fees may also be added to your bill. It is the responsibility of the consumer to review and understand all the terms of the agreement.

Securing Credit

If you have never established credit or if you must reestablish credit, you might consider a secured credit card. A secured credit card is backed by the funds you deposit into a savings account. Your funds earn interest while providing you with charging privileges. You can use a secured credit card just like an unsecured one.

You are still required to make regular payments. If you do not honor the payment schedule, the funds are deducted from your savings account. Your card may also be cancelled for failure to adhere to the agreement. Commonly, additional fees may apply like annual or monthly service fees. There could be an application fee as well.

This type of card is helpful to get your credit history started; however, because of the high interest rates and other excessive fees, you should transfer to an unsecured card as soon as possible.

Some secured cards offer the option to convert to an unsecured card after you establish a record of making your payments in a timely manner. Ask about this conversion feature. If you do sign up for a secured card, confirm that the company will report your payment history to the credit bureaus. This assures that you benefit from your efforts to establish or reestablish a good credit record.

Using Credit Wisely

Once you have obtained your new credit privileges, the next step is to manage your credit wisely. To ensure that you remain creditworthy, follow some basic tips:

  • Limit your access. One or two major credit cards are adequate for most people.
  • Keep your total charges below 50% of your credit limit. Do not carry large amounts of available credit.
  • Pay your balance in full or make more than the minimum payment due each month.
  • Understand all of the fees connected with your card to avoid surprises on your statement at the end of the month.
  • Keep a record of your cards, the account numbers and company contact numbers in a secure place.
  • Request a lower interest rate after you have established a good payment history.
  • Be conservative. Wait until you have the cash for ordinary purchases whenever possible.
  • Follow the six-month rule. Use a card once every six months to keep it current. Charge a small amount. Pay the balance in full when the bill comes and then put the card away. This keeps the card from being cancelled due to inactivity.
  • Do not use a credit card for impulse purchases.
  • Be sure to keep a record of your purchases to avoid going over the limit. This is especially important if more than one person uses the same card.
  • Be wary of the higher credit limit ploy. Paying the balance in full each month could earn you an offer to raise your credit line. Steer clear of this subtle tactic to persuade you to charge more and carry a balance.
  • Request a copy of your credit report each year. Scrutinize the details and dispute erroneous or outdated entries. Contact information for the three major credit reporting bureaus can be found at the end of this chapter.


When a consumer is not able to obtain credit based on their record, they will sometimes be allowed to acquire credit if they add a person with good credit to the account. This person is known as a cosigner. A cosigner pledges to pay the bill if the original borrower defaults on the payment, and is equally responsible for the debt. The account is listed on the cosigner’s credit report. The debt is also taken into account when determining the cosigner’s Debt-to-Income Ratio, thereby reducing the cosigner’s borrowing power.

Cosigning invites financial ruin. It is taking responsibility for something you cannot control – the actions of another person. Do not use your good record to help others get into debt. Remember, if the lending institutions, with their mega resources, will not take a chance on Uncle Joe, then it is unwise for the average consumer to jeopardize his or her limited resources to finance him. It would be better for Uncle Joe to get a secured credit card and build his credit rating directly. Yes, the interest is high, but everyone pays higher rates when trying to establish credit. Just say “No” when it comes to cosigning. This keeps your credit record and your relationships intact. This advice can also be applied to request for loans from family and friends. Most adults who are in constant need of financial assistance are poor money managers. Do not use your funds to perpetuate the pattern.

Credit Reports

Your credit report is a reflection of your credit management skills. It contains the payment history on your accounts. Information is provided by credit reporting agencies. The agencies that gather this data are called credit reporting agencies or bureaus. Although there are hundreds of reporting agencies across the country, three major bureaus provide this service. The three major credit reporting agencies are Equifax, Experian and Trans Union.

Your credit report can be viewed not only by financial institutions, but also by current and potential employers, insurance companies and leasing agents. Your information cannot be viewed by the general public. The Fair Credit Reporting Act stipulates that only entities with legitimate business concerns can access your information.

What’s In a Credit Report?

Your credit report contains your current address, previous addresses, Social Security number, date of birth and a record of your employers. It also lists your credit cards, bank accounts, auto loans, student loans, mortgages and personal loans. Each entry will include the date the account was opened, your payment history, credit limit and any collection activity.

The report also lists legal actions such as judgments, garnishments, bankruptcies, foreclosures and tax liens.

Another section tracks recent requests for your file. These are called inquiries. Multiple inquiries can lower you credit score. If you are applying for credit, try to submit applications in the space of one 30-day period rather than spread them out over several months. This reduces the negative impact of multiple inquiries. Numerous inquiries over several months make it appear as if you are constantly applying for credit and being turned down. An individual can request their own information as often as they wish without affecting their credit rating.


It is important to examine your credit report at least once each year because these reports are not mistake-proof. If you notice an error, write to the company immediately and send a copy of the report with the mistake highlighted. The bureau is obligated to investigate the mistake within 30 days and either correct it or send you the reasons why the entry is valid. If you are not able to remove an entry, you do have the right to attach a personal statement concerning the entry. Anyone requesting your report will be sent a copy of your statement as well. A sample dispute letter can be found at the end of this chapter.

If you are denied credit, you are entitled to know the name of the credit bureau that issued your report. You have 30 days from the date of notification to request a free copy of your record.

General account information is reported for a period of seven years from the date of last activity. Bankruptcies are reported for 10 years. When reviewing your report, be sure to note the date of last activity. Some negative information can be legitimately removed simply because the entry is outdated. You must request that your file be updated. This is not done automatically.

Credit Scores

Your credit score is based on an analysis of the information in your credit report. It summarizes your creditworthiness. Each bureau uses different formulas for calculating a credit score. Some use a separate company to evaluate data. Fair Isaac Corporation (FICO) and Vantage are currently the major players in the credit scoring business. Credit bureaus have also begun to generate scores based on their own method of analysis. Your credit score can vary depending on the source and the system used. Scores generally range from 300 to 850. High scores are more advantageous than low scores.

Likewise, each financial institution uses its own criteria to evaluate credit scores. The following guidelines will give you a general idea of how the numbers are interpreted:

  • 720 and above – Excellent rating, interest and fees are minimal
  • 650 to 719 – Average to good rating, terms are somewhat higher
  • 500 to 649 – Credit is mediocre to poor, interest and fees will be significantly higher
  • 499 and below – very low rating, a poor credit risk, if credit is extended the interest and fees will be exorbitant if not prohibitive

The Components of a Credit Score

  • 35% – payment history (timely payments over an extended period get high marks)
  • 30% – outstanding debt (stay well below credit limits, curb the number of accounts)
  • 15% – length of time you have had the account (older accounts with good payment history are more significant)
  • 10% – new accounts and multiple inquiries
  • 10% – types of credit (a variety of account experience is favorable – revolving accounts, installment plans, loans).

A person with a low credit score will pay hundreds of dollars more in finance charges than a person with a high credit score. For example, on a 3-year auto loan of $15,000, a person with a credit score of 700 will be able to get an interest rate of 8.1% and a monthly payment of $471. A person with a score of 550 can expect an interest rate of 15.98% with a monthly payment of $527.The person with the lower credit score will pay about $2016 more in interest over the three-year period. If your credit score is not at an optimal level, do not despair. Scores improve with the passage of time and with the use of good credit management techniques.

Review Your File

The U.S. Fair and Accurate Credit Transactions Act entitles you to a free copy of your credit report every 12 months. You can request your copy from a Web site, by phone or in writing. It is best to review your file from each bureau because the data can vary. Your credit score is usually not a part of this free service, each bureau will charge a fee for reporting the score. This is the contact information for the three major credit bureaus:

Equifax: P.O. Box 740241 Atlanta, GA 30374. Phone: 800-685-1111.

Experian: P.O. Box 9595 Allen, TX 75013. Phone: 888-397-3742.

TransUnion: P.O. Box 1000 Chester, PA 19022. Phone: 800-888-4213.

You can also get your free copy from the Annual Credit Request Service. You can contact them online, by phone or in writing:

Annual Credit Request Service
P. O. Box 105281
Atlanta, GA 30348-5281
Phone: 877-322-8228

Reviewing your credit record regularly can alert you to mistakes and fraudulent activity. It can also ensure that you get the best rates and terms available by providing an opportunity to make corrections before applying for financing.

Protecting Your Information

Monitoring your credit file and reading your account statements thoroughly protects you against the unauthorized use of your information. Be sure to take immediate action if you notice charges that you did not approve or if an account is listed that you did not apply for.

In addition to calling the customer service line, it is also best to contact the company in writing. Keep a list of all account information along with the company phone numbers. This will make it easier for you to file a report if you lose your cards. Most companies have strict policies in place to protect consumers from erroneous charges if reported in a timely manner. Vigilance is the key.

Consumer Credit Laws

The Consumer Credit Protection Act of 1968 called for fairness and equality in the treatment of consumers. This legislation and similar laws passed since that time protect consumers from unfair, deceptive and abusive credit practices. Major provisions of the most frequently referenced laws are listed below:

  • The Fair Credit Billing Act requires creditors to respond to a notice of a billing error within 30 days and resolve the matter within two billing cycles. Any amount that is disputed cannot accrue finance charges or be turned over to a collection agency during the investigation process.
  • The Equal Credit Opportunity Act prohibits creditors from discriminating against applicants on the basis of religion, sex, marital status, nationality, age or race. It also prohibits creditors from denying credit solely because a person receives public assistance such as food stamps and Medicaid.
  • The Fair and Accurate Credit Transactions Act requires that consumers be allowed to receive a free copy of their credit report from each of the three major reporting agencies once every 12 months.
  • The Fair Credit Reporting Act controls the dissemination of your information. It states who can have access to your information. It also makes it unlawful for agencies to report negative information after a specified time period. Those who violate this law can be sued for damages. This law allows you to exclude your name from lists for unsolicited credit or insurance offers. It also stipulates that your consent is required for reports provided to employers or for reports that contain medical information.
  • The Fair Debt Collection Practice Act controls the activity of collection agencies. It limits the time and manner in which representatives may contact consumers concerning delinquent accounts.
  • Truth In Lending Laws require creditors to divulge the actual costs associated with financing. Due to this disclosure requirement, consumers can now make accurate comparisons between lenders.

For complete details on all of the credit laws and how they may be applied, contact the Federal Reserve Board:

Federal Reserve Consumer Help
P. O. Box 1200 Minneapolis
MN 55480 888-851-1920
Phone: 877-766-8533
Fax: 877-888-2520

In This Chapter You Learned:

  • The benefits of credit.
  • Interest and other costs of using credit.
  • How to obtain credit.
  • How to use credit wisely.
  • All about credit reports and credit scores.
  • How to protect your information.
  • What you need to know about consumer credit laws.

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