There is no shortage of the types of credit available. Our reader, Mike, asked about how to choose what’s best for you. Follow along as our expert, Mubina Kapasi, a CFA, answers him.
The question
Good afternoon,
Mike T., Brandon, MB
I’ve decided to re-examine what I have for credit. Whenever I got credit before I never really put much thought into it. I just kinda went with what was available. Now that I’m taking another look I want to put a little more thought into what I choose and how I switch things around. What should I be considering as I do this?
Thanks,
The answer
Hi Mike,
An examination like this is very well warranted and indicates a healthy financial and credit journey. The question engenders the topic of what is considered good credit and what is labelled as bad credit. At the risk of stating the obvious, you want to drop bad credit from your credit mix as far as possible. To identify a line of credit as good credit or bad credit you must ask yourself the purpose of borrowing money and the net cost you’re paying for it.
Purpose of taking credit
First, ask yourself what expense is being met or what goal is being achieved with the line of credit. It would usually be towards an asset – a home, car, or revenue expenditures like shopping and electronics. It may also be to meet financial emergencies, like when your budget for a month may have gone out of whack!
When you take out a loan for a home, you are investing in an asset that could create wealth for you by way of appreciation in value or tenancy. Similarly, when you take a student loan, you are investing in yourself and your chances of better career prospects. Even a credit builder loan improves your financial prospects as long as it is paid in time as it helps build credit. These loans help achieve long-term monetary goals.
Now consider credit card debt, personal loans, installment loans, payday loans and auto loans. Credit cards, especially ones with high credit limits, could entice the user to make frivolous purchases. Auto loans are for an asset, a vehicle. While cars are considered an asset, they depreciate very fast and the car’s value drops low. Far less than what the loan you took out to buy it.
There’s another category of expenses, emergencies. Loans that cater to this category are very accessible While it’s best to use them sparingly, payday loans and cash advances on credit cards can be obtained quickly and used to meet emergency expenses. They can also be useful for those months when your budget has gone awry.
Cost of the credit facility
Financial costs
Cost of credit takes the form of interest, annual fees and penalties. Usually, secured loans and instalment credit tend to have a lower interest rate. Types of secured loans are home equity lines of credit and auto loans. Unsecured credit cards, personal loans and credit card cash advances are types of unsecured credit. They carry high-interest rates.
The average interest rate (also known as Annual Percentage Rate or APR) for credit cards is 19.9%. Credit card cash advances tend to incur a 3-5% flat fee, ATM fees, and a steep 23-25% interest rate.
Credit score costs
The impact on your credit score should also be considered as a cost. When you borrow money, credit bureaus note the type of line of credit obtained. Credit cards are a type of revolving credit. When you use revolving credit well, it indicates to credit bureaus that you manage your money, thus improving your credit score. A secured credit card can in fact be a good tool to establish a credit score if you’re new to credit. Cash advances and Payday loans on the other hand are a sign of just the opposite. because they’re taken when you run out of money before payday or when you lack emergency savings. That being the case, they can have a bad impact on your credit score.
Reward costs
Credit cards when used well, can be rewarding. Reward points come in the form of different credit card offers, cash back, travel rewards and more. Different types of credit cards offer different kinds of rewards. The first step to picking the right one for you is to identify the expenses that you swipe your credit card for the most. The second step is to identify if there is a particular service provider or retailer that you use most often to cater to the above expense. If groceries and travel are the most common credit card spends, it is worth taking a store credit card for the former and a miles card for the latter. Dividing expenses could also help stay within the credit limit and in managing the credit utilization ratio.
Other cost consideration
After considering and comparing costs and rewards, you could use a tool called a balance transfer. You can transfer the credit card balance from one creditor to another that offers lower interest or better benefits This helps prevent credit card debt from ballooning to unmanageable levels.
Good credit and bad credit
Good debt contributes to creating wealth and towards your earning potential. Bad debt nudges you to make purchases and increases your expenses. Good debt comes with lower interest rates and is not detrimental to your credit score. Bad credit has higher interest rates and charges. They can hit your credit score because credit bureaus can see some lines of credit as indicative of bad saving and budgeting habits. Good credit usually comes with more credit terms, but those help you keep your expenses at sustainable levels. Bad credit can be availed easily and thus can suck you into the vortex of indebtedness.
As far as possible these are the loans you want to avoid:
- Payday loans
- Cash advances against credit cards
- Personal loans
A mix of revolving and instalment credit will go a long way to keep credit costs down and improve your credit.
About Mubina Kapasi
Mubina Kapasi is a financial journalist and co-founder of an Indian startup that’s developing a vernacular financial literacy platform. She holds a CFA here in North America, as well as, the equivalent of a CA in her home country of India, Giving her a unique and thorough perspective on the world of finances.
Mubina took her knowledge even further as she studied the Canadian stock markets, mortgage and retail loan markets in detail while living in Toronto. Prior to that, she was an equity and commodity research analyst and a prime-time news anchor with ET NOW, a part of India’s largest media house – The Times Television Network.
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