Cost of Credit

To a child, it might seem like the little plastic credit card mommy or daddy uses to get groceries at the store or gas for the car must be magic, since they don't have to pay for anything. But of course, the reality quickly sets in when that child grows up and obtains his or her own credit card, which comes complete with a cost.

Credit, whether in the form of a credit card or a loan, always has a cost associated, beyond the obvious need for paying back what was borrowed in the first place. The cost of credit can generally be broken down into two factors: annual percentage rate and finance charge. The annual percentage rate is the amount in percentage points that you will pay per year in interest on your borrowed money. This amount will vary depending on whether you have a secured or an unsecured line of credit. A secured line of credit is simply one in which there is collateral, as in a mortgage where a house is often given as collateral in the event the debt is unable to be paid off, in which case the lending institution may collect the house in lieu of payment. The interest charges on this type of line of credit typically will be lower than that on an unsecured line of credit.

An unsecured loan is one in which there is no collateral involved, and therefore the annual percentage rate is generally much higher than for a secured loan. A credit card is an unsecured line of credit, and therefore a typical annual percentage rate can be around 18.5%. The finance charge includes all fees related to having the line of credit, including interest fees, service charges and even the cost of insurance premiums that creditors take out on their loans, passing the cost on to the consumer.

Because lending agencies are required by law to disclose both their finance charge and their annual percentage rate, it is possible to do some comparison shopping to see which company offers the best rates. However, your own credit history will determine whether you are eligible to receive a company's best rates or not.

A credit lending institution will check your credit report prior to issuing you a line of credit, and if they find any credit issues indicative of a poor credit history they may not give you the loan or credit card you desire. Their first priority is to manage their credit risk, and therefore they determine who is "safe" to lend money to and who is not.

Although it may seem unfair that credit institutions have this power over you, keep in mind that you have a similar power over them- you do not have to borrow their money, especially if the cost of credit proves to be too high for your liking. Most people are unaware of the potentially crippling cost of credit.

For example, let's suppose that you have a credit card with an annual percentage rate of 15%, which is lower than the norm. And let's also suppose that there is no finance fee on this credit card. You make a purchase of $1000 on your card, but discontinue using it after that initial purchase. After one year, you will owe $1150, which isn't all that extraordinary, and is even quite acceptable. However, in real life, it is almost never that simple, is it?

Chances are, your credit card company will send you a monthly bill with a minimum payment amount on it, often just 5% of the entire bill. If you make the common mistake of only paying this minimum, you will take much longer to pay off your debt, and it will cost you much more in the long run. And of course, in real life you would likely be adding more purchases to your account, accruing more debt and more interest charges. It doesn't take long before even the most diligent consumer is trapped in a downward spiral of increasing debt load.

This can be avoided if one is just aware of the cost of credit, and takes a few simple steps to avoid being overwhelmed by it. The first step is simple- make more than the minimum payment. If at all possible, pay off your entire balance as soon as you are able, and as often as you are able. This will keep your interest payments to a minimum as well as having the positive effect of giving you a good credit history.

Another thing you can do is add up the total cost of the interest and other fees you paid on your credit card in the last year, and compare it to the total cost of the purchases you made. This can be a sobering but integral demonstration of the cost of credit. If you feel you have paid too much on the money you have borrowed, then perhaps it is time to re-evaluate whether having a credit card is really worth it. You need to have a good credit history of course, but once you have established that, seriously consider retiring your plastic.

It turns out the little child was right - credit cards are magic after all, but not good magic.