How the strategic use of leverage can help you grow your wealth.
From buying a new home or car to starting a business, sometimes you have to go beyond what’s in your checking or savings account. That’s where credit comes in–you can finance large purchases over time and pay either a fixed or variable interest rate on your balance. Properly managed, credit can be an excellent way to cover sizable expenses without impacting your liquidity, existing investment strategy, or day-to-day lifestyle. These basic definitions will help you sort through the process for obtaining credit.
Managing your credit score
Lenders use your credit as a factor in determining your eligibility for credit. Depending on the reporting agency (the three major agencies are TransUnion, Equifax, and Experian), scores range from about 300-850, with anything above 700 considered a strong score. To establish and maintain a strong credit score/credit history, you should always pay your bills on time.
The most basic type of credit account, credit cards can also be the most confusing, due to wide variations across fees, interest rates, spending limits, and other features, such as cash back and loyalty programs.
The basic process is this: with a credit card, the issuer gives you the ability to make purchases within your pre-established credit limit on a revolving basis (each period, as long as you don’t hit your credit limit), and you’re responsible for paying against your balance each month. For day-to-day purchases, credit cards offer many protections above using a debit card, one of which is the lack of direct access to your bank accounts.
Open-ended versus closed-ended loans
Open-ended loans are loans that allow you to put money in (make a payment) and take money out (make charges or cash withdrawls). These loans have credit limits that you cannot exceed without penalty. They are flexible loan products that provide the consumer with options. On an open-ended line of credit, you only pay interest if a balance is kept at the end of the statement period. One of the benefits of an open-ended line of credit is that the credit limit can be increased if the card is managed responsibly.
Examples: Credit cards such as Visa, Discover, and American Express. The cards allow you to charge up to a certain limit. Lines of credit, such as a home equity line of credit, are also examples of open-ended loans.
Closed-ended loans Are loans that are set from the beginning. You can make payments into it, but cannot take money out. The money is loaned at a set amount, and the consumer agrees to make payments towards the principal and interest. Also known as installment loans, you can make additional principal payments and pay them off early, but once paid you do not have access to the equity in the property that you have purchased. Typically, interest is paid in the early years of the loan, and principal is paid towards the end of the loan period. The only way to access equity is to sell the property or to get a new loan, i.e., refinance.
Examples: car loans, 30-year mortgage, 15-year mortgage, adjustable rate mortgage
Designed to help finance the purchase of a used or new vehicle, auto loans function in a similar fashion to mortgages: lump-sum payout, pre-determined payment amounts and interest rates, and a set payment schedule (usually no more than 60-72 months). Much like a mortgage, if you miss payments, you risk repossession of the vehicle.