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People in the 18 to 24 age bracket spend nearly 30% of their monthly income just on debt repayment - double the percentage spent in 1992 (10% of net income is a recommended amount for debt obligation).

FDIC Center for Financial Research

Use The Right Tool for the Job

Right toolFor most every purchasing decision, there is a credit option that can do the job well. With some small purchases the decision is easy. But with larger purchases, use the information we’ve covered thus far to weigh the true costs, risks, and implications for your score of all your available options.

As we’ve seen, not all credit is the same. In general, some forms of debt, such as payday loans and rent-to-own agreements, can cost many times more than other types of credit. Other revolving forms, such as credit cards, have their dangers, but can be a useful financial resource when used wisely. By knowing how each type of credit works, you can start to understand what your credit options are and how to pick the one that is right for your situation.

Using this process, let’s examine a hypothetical purchase: After arriving at your new base, you need new living room furniture. You decide on a set that sells for approximately $1,000. Naturally, you want to get the best deal you can with the lowest monthly payments. Let’s look at the options that might be available to you, and the upside and downside of each:

Saving piggy bank

Consider saving for the purchase.

If you have time before making your purchase, take the money you would have spent in payments each month and deposit it into a Savings Account. Although you won’t be able to get the item right away, effectively you’ll be saving the interest paid on whatever loan you would have taken out, plus the interest you earn on your money while in savings.

Not only will you reach your goal of true ownership much faster, but you will have saved yourself a lot of money, as well.

Existing credit card.

Let’s say you have a number of credit cards, each with a zero balance. You decide to put the purchase on one of the cards and pay it off over time.

Upside:

  • Very low minimum monthly payments
  • Easy to use, just swipe and go

Downside:

  • Higher APR, typically around 12%1
  • Carrying a balance on a revolving charge can negatively impact your credit score
  • In the event of an emergency, you won’t have the credit available that you used to buy the furniture
  • It’s tempting to make only minimum payments, which can prolong the loan repayment for many years and cost you much more in interest over time
  • If you are late on a payment for any reason, you’ll probably be charged a fee, and your APR could increase drastically as a result of violating the "Universal Default Agreement"

Store credit card.

The furniture store is offering 10% off the price of the purchase if you open a new, revolving store charge account.

Upside:

  • In some cases they may offer a discount or savings upfront
  • No down payment required or payments can be deferred

Downside:

  • Your credit score can be reduced for opening a new credit account
  • This card will likely have a lower balance than a standard credit card, so your score will be less likely to fully recover or improve over time, as with other cards
  • Like other credit cards, store cards may also have a "Universal Default Agreement" that can cause your rates to increase drastically

Rent-to-own.

The rent-to-own store is offering the same furniture with a low weekly payment. This is effectively a secured loan, but typically with a high APR.

Upside:

  • Lower weekly payments, rather than monthly, are sometimes available
  • Receive the furniture immediately

Downside:

  • If you are unable to make payments, you may lose the furniture and any payments you’ve already made
  • Very high APR

Unsecured bank loan.

Taking out an unsecured bank loan, such as a Signature Loan, allows you to borrow the amount you need at a reasonable, fixed interest rate.

Upside:

  • Fixed loan payments and terms
  • Low interest rates, compared with most other types of credit
  • Easy Online Application Process
  • Over time, may improve your credit score by adding an installment loan to your mix of available credit
  • Automatic deductions from your checking account helps ensure you never miss a payment and allow for a lower APR

Downside:

  • Not available immediately at the time of purchase and must be applied for prior to purchase

Bank line of credit.

Similar to an unsecured loan, both in terms and rates, a line of credit allows you to pay interest only on the amount of credit you actually use, like a credit card, but has the stability and interest rate of a bank loan.

 

1. Typical credit card loan rate provided by  creditcards.com index and was 12.41% as of May 19, 2008