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Personal Finance Unit 4: Credit and debt

Credit lets you borrow now and pay later, but interest adds to the cost, and your credit history affects future borrowing.

Covers: How credit works, credit cards, loans and interest, credit reports and scores, student loans, managing debt

Study guide

Credit is the ability to borrow money with a promise to repay. Revolving credit, like a credit card, lets you borrow up to a limit repeatedly; installment credit, like a car loan or mortgage, is repaid in fixed payments over a set term. Lenders charge interest, expressed as the annual percentage rate (APR), which includes some fees. Secured loans are backed by collateral (like a car), while unsecured loans aren't, so they usually have higher rates. A cosigner promises to repay if the borrower doesn't.

Credit cards are convenient and build credit when used responsibly, but they can be expensive. Paying the full statement balance by the due date avoids interest thanks to the grace period. Paying only the minimum payment means the balance takes years to pay off and costs much more in interest. Late payments bring fees and can raise your rate. The Credit CARD Act of 2009 added protections, like limits on fees and rules for young adults. Predatory lending, such as payday loans with extremely high APRs, traps many borrowers in debt.

A credit report records your borrowing and payment history. The three major credit bureaus are Equifax, Experian and TransUnion, and you can get free reports at AnnualCreditReport.com. A FICO credit score ranges from 300 to 850 and is based mainly on payment history (35%), amounts owed or credit utilization (30%), length of credit history (15%), new credit (10%) and credit mix (10%). Keeping utilization low, under about 30% of your limit, and paying on time improve scores. Good credit leads to lower interest rates on loans and can affect renting an apartment. Student loans include federal loans, with fixed rates and flexible repayment options, and private loans, with fewer protections; students should fill out the FAFSA and borrow only what they need. Debt repayment strategies include the avalanche method (highest interest first) and the snowball method (smallest balance first).

A credit report lists personal information, credit accounts and payment history, inquiries, and collections or public records such as bankruptcies. Most negative items stay for about seven years, and some bankruptcies stay longer. Under the Fair Credit Reporting Act you can dispute errors with the credit bureau and the company that reported the information. Checking your own credit is a soft inquiry and doesn't affect your score. A hard inquiry happens when you apply for new credit and can lower your score slightly for a short time.

People have several credit scores because lenders use different scoring models, such as FICO and VantageScore, and different bureau data. Lenders, landlords, insurers, utility companies and, with your permission, employers may check your credit report. Borrowing that builds long-term value, like an affordable student loan or a reliable car for work, can be reasonable if the payments fit your budget. Your debt-to-income ratio is your monthly debt payments divided by your gross monthly income. Lenders use it to judge whether you can afford more debt.

Under the Fair Debt Collection Practices Act, debt collectors can't harass you or lie. If you ask in writing, they must stop contacting you, except to confirm the request or give notice of a specific action like a lawsuit. Stopping contact does not erase the debt. People with no credit history can build one with a secured credit card, a credit-builder loan or by becoming an authorized user on someone else's card, then paying on time every month.

Key ideas

• Revolving credit can be reused; installment credit has fixed payments.
• Paying a card's full balance avoids interest.
• Minimum payments greatly increase the total cost of debt.
• Payment history and utilization are the biggest factors in a credit score.
• Federal student loans offer more protections than private loans.

Formulas and rules

Common mistakes

• Thinking carrying a balance helps your credit score; paying in full is better.
• Thinking checking your own credit report lowers your score; it doesn't.

Words to know

Credit

Borrowing money with a promise to repay later.

Revolving credit

Credit you can borrow repeatedly up to a limit.

Installment credit

A loan repaid in fixed payments over a set term.

APR

Annual percentage rate, the yearly cost of borrowing.

Collateral

An asset that secures a loan.

Secured loan

A loan backed by collateral.

Unsecured loan

A loan not backed by collateral.

Cosigner

A person who agrees to repay if the borrower doesn't.

Grace period

Time to pay a credit card balance without interest.

Minimum payment

The smallest amount due on a credit card bill.

Payday loan

A short-term, very high-interest loan.

Credit report

A record of a person's borrowing and payment history.

Credit bureau

A company that collects credit information.

Credit score

A number summarizing creditworthiness.

Credit utilization

The share of available credit being used.

FAFSA

The federal form to apply for college financial aid.

Avalanche method

Paying off the highest-interest debt first.

Snowball method

Paying off the smallest balance first.

Sample practice questions

11 more questions like these, from level 1 to 5, are in the practice set.