Lesson 2: Using Credit Wisely – Napkin Finance

Lesson 2: Using Credit Wisely

Understanding the cost of credit

News flash: Borrowing money isn’t free. Anytime you take on debt, you will pay for doing so. How much you pay depends on the interest rate your lender charges. Many types of debt come with a fixed interest rate, such as 5% a year, that won’t change over the life of your loan. Other loans have a variable rate that can move up and down, depending on what’s happening in the economy. In some cases, such as when you take out a mortgage, you’ll also pay up-front fees on a loan.

What interest rate you pay generally depends on how worried your lender is about being paid back. If your lender thinks it’s making a safe loan to you, then you’ll pay a lower rate. Short-term loans typically come with lower rates than long-term loans. If you’ve been meticulous about meeting debt payments in the past, then you probably have a good credit score and will qualify for a better-than-average rate. Rates will also be lower if your lender can repossess a physical object, such as your house or your car, if you don’t pay back the loan.

Loans that usually have low rates include:

  • Mortgages
  • Auto loans
  • Federal student loans

Loans that usually have high rates include:

  • Credit card debt (if you don’t pay off your balance in full each month)
  • Payday loans

Taking care of your credit score

Whether you have a good or bad credit score can make or break certain moments in your life. With a good score, you might be able to afford your dream house. With a bad score, you might not be able to get a mortgage at all. And it can take a long time for your credit history to recover after a taking a hit, so it pays to treat it with care. To protect your score, you should never miss a minimum payment. It also helps your score to keep your total spending below one-third of your credit limit. 

For example, if your card has a limit of $10,000, try to keep your outstanding balance below $3,000. You can also protect your score by not applying for new lines of credit.

Tips for paying down debt

  • Always make all your minimum payments. That protects your credit score.
  • Pay down debt with the highest interest rate first. That’s probably your credit card debt.
  • Prioritize paying off high-rate debt over saving for long-term goals. Saving for that down payment can wait until after you’re free from that 18% credit card debt.
  • Beware of debt consolidation and debt settlement offers, which can be run by scammers.
  • If you’re still having trouble digging out of debt, revisit your budget.
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