Buy Now, Pay Later
Credit is essential to the efficiency of the modern economy. It enables consumers to get the goods and services they want today in exchange for the promise to pay in the future. In the U.S., nearly all structures and motor vehicles are paid for with borrowed money. While it is cheaper to pay for these goods in cash, credit allows consumers to take advantage of important opportunities now and not tie up as much money in accounts reserved for emergencies.
But there are pitfalls. Obtaining credit can expose a person’s income, assets, current standing with the financial community, and future borrowing opportunities to risk. If the borrower repays only the minimum amount required each month, a mountain of debt can grow quickly and take many years to repay. The ultimate risk is that the borrower will default on the commitment to repay the creditor, which can affect the person’s credit rating and result in reduced credit access, higher borrowing costs, or both.
For many who use credit, the drift into debt occurs painlessly—and both government policies and private lending practices encourage it. The result is an alarming growth in consumer debt. The Federal Reserve reports that consumer debt in the U.S. totaled a record $3.31 trillion at the end of 2014. This is more than triple the level of consumer debt 20 years ago.
This guide will cover the following topics:
- What You Need to Know about Credit Cards
- Consider costs
- Promotional offers
- Borrowing Beyond Credit Cards
- Consumer protections
- How Lenders Evaluate Credit Potential
- Maintaining a Good Credit Rating
- Credit complaints
- Avoiding credit card fraud
- Repairing your credit
- The Consequences of Unwise Credit Use
- Deciding on bankruptcy
If you are new to credit, you can take a number of paths to start to build a credit history. You can open a checking and savings account, apply for a retail credit account, find a co-signer, apply for a secured credit card, check with an employer about getting a reference for a loan, or consult a local credit union or affinity group that helps its members secure credit.
When looking to apply for a loan, start with your bank and then consider alternative institutions as well. You will need to know the loan’s annual percentage rate (APR), total fees and finance charges, monthly payment, and total cost. Creditors offer loans that are either secured (backed by an asset like a home or car that can be used as collateral) or unsecured (not backed by any collateral). A secured loan is less risky for the creditor because if you default on the debt, the creditor can seize the pledged asset. An unsecured loan relies solely on the creditworthiness of the borrower, making it riskier for the creditor. As a result, these loans carry a higher interest rate.
When shopping for a credit card, consider the differences in annual fees, grace periods before interest accrues, interest rate charges, and methods for calculating finance charges. These factors vary in importance depending on whether you pay just part of the balance each month, pay the balance in full, or do some combination of these things.
For information on specific credit card plans, look to the Consumer Financial Protection Bureau’s semiannual Survey of Credit Card Plans, which compiles data on the fees and terms of thousands of credit card plans. You can also get a sampling of credit card incentives at websites such as www.cardweb.com and www.bankrate.com.
Credit cards are a costly way of borrowing. It is not unusual for a credit card to have an APR of 19.9% or higher and if you pay only the minimum balance each month, it can take years to repay even a modest credit balance. Many people do not realize just how expensive credit card borrowing can get until it is too late.
To address these problems, the Federal Reserve, the Office of Thrift Supervision, and the National Credit Union Administration adopted several provisions in 2010 to regulate practices for consumer credit card accounts. The rules were designed to better inform consumers about credit card policies and help them see the true costs of borrowing with credit cards. One result is that credit card issuers are now prohibited, with a few exceptions, from increasing the APR during the first 12 months an account is open. When an APR increases at any point, the credit card issuer must notify the customer at least 45 days in advance and apply the new APR to balances accrued after the rate change. Credit card issuers must also send out billing statements at least 21 days before payment is due so customers have sufficient time to make prompt payments.
Credit card issuers often send customers a broad assortment of special promotions, ranging from rebate programs to membership in various organizations. Two types of these offers—balance transfer offers and credit protection plans—relate to borrowing and credit. In a balance transfer offer, a credit card issuer allows a borrower to use the account’s credit line to pay balances on other accounts, including loans, credit cards, or other bills. To determine whether or not the offer is worthwhile, the borrower must evaluate the APR offered for the transferred balance, the length of time it is in effect, and the transaction fee charged.
Credit protection plans offer to make the minimum required payment on a customer’s credit card account in case a qualifying event occurs. The qualifying event could include a job loss, hospitalization, or even a long-distance move or the birth of a child. Some plans offer to repay the full balance on the credit card in the event of the cardholder’s death. The supposed advantage of these plans is that the credit card issuer will pay minimum balances at times when it might be difficult for the cardholder to do so. However, the plans are almost never a good idea—they are expensive and it is unlikely that the benefits will outweigh the costs.
Credit cards are widespread but they aren’t the only means of borrowing. Consumers typically turn to other types of loans for big-ticket items like automobiles, homes, home improvements, and college tuition. Each type of loan has its own rules. Here are some points to consider for several common types of borrowing:
Auto loans: Many consumers rely on dealer-arranged financing to pay for a car. The dealer’s offer will quote an APR based on the customer’s credit history, current finance rates, competition, market conditions, and special offers. The dealer receives compensation for these services, either in the form of an APR markup or a fixed fee charged to the consumer. Unless the APR is part of a special offer, it is subject to negotiation. It helps to investigate auto loan rates offered through other lenders, like banks or credit unions, before visiting dealerships.
Mortgages: A mortgage is a loan for which a home is pledged as collateral. The formula for borrowing used to be simple: A person could borrow up to 80 percent of the home’s appraised value and finance it over a 15- or 30-year period at a fixed rate. New types of mortgages have appeared over the years, among them adjustable-rate mortgages, interest-only mortgages, and negative-amortization mortgages. Be sure to shop around for a mortgage—don’t rely solely on your real estate broker or even your local bank. The key features of a mortgage contract are the interest rate, the term of the mortgage, and the fees involved. Pay special attention to whether the interest rate is fixed or adjustable, and if it is adjustable, how often and how much it can change. The Federal Reserve provides these resources to help consumers find the right mortgage.
Borrowing against home equity: Consumers can borrow against the equity in their homes to consolidate high-interest credit card debt, pay tuition bills, or make home improvements. On the positive side, the rates on home equity loans are often lower than most other forms of financing and the interest is tax-deductible. They may make sense for borrowers who spend within their means and borrow selectively. On the negative side, these loans erode home equity and may leave consumers with mortgage and home equity loan costs that exceed the current market value of their house.
Education loans: In an age where the cost of a college education runs well into the six figures, borrowing to pay for college is a necessity for many students and their parents. According to a report from the Institute for College Access and Success, 69 percent of graduating college seniors in 2013 left school with an average of $28,400 in student loan debt. Education loans fall into three main categories: federal student loans (Stafford or Perkins loans), federal parent loans for undergraduate students (PLUS loans), and private loans. Federal education loan programs typically have lower interest rates and more flexible repayment options than do most consumer loans. That said, students assuming these loans should estimate their future earnings realistically to ensure they can manage the burden of education debt.
Borrowing from a retirement account: It is possible to borrow money from an individual retirement account (IRA) or a retirement account offered by an employer. However, because these accounts are set up to accumulate funds for a future date, there can be penalties for withdrawing funds prematurely. While contributions to these accounts are typically not subject to income taxes, distributions are. As a result, the account holder will deplete retirement savings and have to pay tax on the distribution on top of that. IRAs can provide a good short-term borrowing alternative. As long as the account holder deposits the borrowed amount into another IRA or the same IRA within 60 days, no income tax is owed. It is important to plan carefully and investigate current tax rules before borrowing from any retirement account.
A number of laws protect the rights of people who use credit. The Equal Credit Opportunity Act requires a creditor to make an impartial assessment of a borrower’s creditworthiness and treat all applicants equally, regardless of age, sex, marital status, race, religion, or national origin. The Fair Credit Reporting Act allows consumers to examine and correct mistakes on their credit records and the Fair Credit Billing Act helps them address billing errors, thereby protecting their credit records.
Disclosure laws, particularly the Truth in Lending Act and the Fair Credit and Charge Card Disclosure Act, are designed to help consumers make better-informed judgments as they shop for credit. The Truth in Lending Act requires creditors to supply customers with uniform information about the rates and terms of a loan so applicants can evaluate terms offered by other sources. The Fair Credit and Charge Card Disclosure Act further requires that credit card solicitations and loan applications divulge the APR, annual fees, minimum finance charges, cash-advance fees, transaction charges, late or over-the-limit fees, grace period, and the method used to calculate the outstanding balance.
Those who decide to co-sign for a loan have the same protections as the primary credit user—but also the same liabilities. A person with a solid credit history and earning capacity may co-sign for a loan if the borrower’s credentials do not meet a creditor’s criteria for granting credit. This makes the co-signer legally bound to assume the debt if the borrower fails to pay. The negatives of being a co-signer tend to outweigh the positives. Those who choose to co-sign a loan should ensure they can afford to pay the debt in case they have to, consider the potential liability the debt will have if and when they apply for a loan themselves, collect a written notice that fully describes the extent of their liability (the Federal Trade Commission’s Credit Practices Rule requires this of creditors), and get written confirmation that the lender will notify them if the borrower fails to make a payment.
When analyzing a credit application, a lender considers the borrower’s willingness to repay the debt and honor the obligations of the loan contract, financial capacity to repay the debt, and the portion of assets pledged to secure a loan. This information, along with a borrower’s computerized credit score, helps lenders determine the creditworthiness of a borrower.
According to Fair Isaac and Company, which develops the most commonly used computerized credit scoring models, these factors carry the most weight in a credit score: credit payment history, debt utilized relative to the overall credit limit, length of credit history, number of new credit applications, mix of credit experience, annual gross income, debt-to-income ratio, the size of the existing credit experience, occupation, age (older applicants tend to get more points than younger ones), whether the person is a homeowner or renter, length of stay at current residence, job stability, and whether the person has both a checking and a savings account.
The best way to get a high credit score is to use credit responsibly, have a good mix of credit, pay bills on time, and have a stable, high-paying job. This can only be achieved over a long period of time but there are steps a person can take in the short term to improve a credit score as well. Merging several credit cards from the same issuer into one card with a larger credit line can help, as can canceling credit cards with low credit limits. Avoid applying for new credit cards, which reduces the average length of time all revolving accounts have been open and can potentially reduce the average credit line if the card has a low credit limit. Finally, reduce outstanding balances—keeping the outstanding balance below 50 percent of the credit line on each credit card is preferred.
Credit scoring is designed to help lenders identify people who will not borrow more than they can repay. But the system has limitations. The most prudent and financially responsible applicant may have difficulty obtaining credit simply because he or she has never borrowed money before. It also leaves little room for unusual circumstances, like multiple credit inquiries within a six-month time frame, which affect a person’s score but have little to do with his or her capacity to repay the loan. It is important for the borrower to understand what lenders are looking for to make the best case for creditworthiness.
Banks, finance companies, credit unions, and retailers rely on information supplied by local or national credit bureaus to determine how consumers use and pay their accounts. This information is readily available to consumers as well. Each of the nationwide credit bureaus—Equifax, Experian, or TransUnion—must provide consumers with a free copy of their credit report, at their request, once every 12 months. They must also provide a free credit report if a person requests it within 60 days of having been denied credit, employment, or insurance as a result of a poor credit record.
If you request a credit report, you will find information about your current payment history and level of debt, as well as late payments, tax liens, and bankruptcies. Other information may not appear. Student loans, even those in good standing, may be unreported. If lenders do not report mortgage payments of homeowners to credit agencies, those payment will not appear either.
It is a good idea to check your credit report periodically. Particularly if you plan to apply for a major loan in the coming months, you will want to have ample time to correct any errors so they don’t negatively impact a lender’s decision.
There are ways borrowers can protect themselves against erroneous and outdated credit information that could jeopardize privacy and future borrowing opportunities. The Fair Credit Reporting Act allows consumers to contest items in a report that are inaccurate or outdated. Credit bureaus must investigate those items within 30 days. If the organization that reported the information cannot verify it, the item must be deleted from the credit report. Once the credit report is corrected, the borrower can have the credit reporting agency notify lenders who received the inaccurate report in the last six months. The agency must also notify other credit reporting agencies of the correction.
Even in the absence of erroneous information on a credit report, there are some protections in place for consumers. If a disputed item on a credit report is verified by a creditor, the borrower has the right to add a statement to the credit file to explain. The law also limits release of a borrower’s credit report to people and organizations with a legitimate business need for the information.
Credit card accounts in particular are subject to a variety of billing errors that can be costly. This can include charges for merchandise you did not buy or services you did not receive, unauthorized purchases charged to your account, purchased items listed with the wrong amount or date or purchase, failure of the credit card company to credit an account for a payment, or mathematical errors in the entries. Check monthly statements carefully so you can catch errors promptly.
The Fair Credit Billing Act was designed to allow consumers to quickly correct errors that, if neglected, could harm their credit record. It gives consumers 60 days from the date the bill was mailed to notify the creditor in writing about errors. It is wise to send the letter by certified mail, with return receipt requested. The creditor has 30 days to respond but no more than 90 days to resolve the disagreement. In the interim, the borrower can withhold interest and minimum payments on items in question and the creditor cannot report the nonpayment to credit bureaus while the dispute is being resolved.
The law makes credit preferable to cash in a couple of ways. If you pay cash for an item and it is never delivered, it may be difficult to get the item or your money back. Paying with a credit card enables the purchaser to refuse to pay the bill if the item is not delivered. The law also provides that in the case of lost or stolen cards, the cardholder does not need to pay for any unauthorized charges after notifying the card issuer. If the credit card is lost and the cardholder reports the loss immediately upon discovery, the cardholder’s liability for unauthorized charges is limited to $50 per card even if hundreds of dollars in unauthorized purchases have been made.
Losing a credit card or having one stolen can be vexing. Increasingly sophisticated Internet predators and other scammers can damage a cardholder’s credit history because the cardholder may not even learn of the fraud until weeks after it occurs. You can protect yourself from credit card fraud and identify theft by taking these steps:
Watch for suspicious emails—don’t trust an email that asks you to reconfirm your account information or other personal details. You can always call the company to check the authenticity of an email message you receive.
Practice financially safe online behavior. Monitor your account transactions and balances regularly. This will alert you to suspicious transactions much sooner than periodic paper statements, enabling you to resolve problems more easily. Also, choose a complex password consisting of numbers and letters, use a different password for each online account, and change your passwords every six months.
Do not click on a link within an email from your bank even if it appears to be legitimate, as fake websites can be made to look like the real thing. Identify a secure website by confirming that the web address begins with https:// as opposed to http://. When you establish online access to your bank or credit card account, which you should always do from your home computer, check the option for the site to remember your name (though not your password) so when you visit in the future, the site will automatically display the name in the appropriate field. Fake websites will not be able to do this.
Install reliable anti-virus software on your computer and update it regularly. Many computer viruses are designed to collect sensitive information from your computer. Never access sensitive financial information from a public computer.
Never give out credit card information over the phone unless you initiated the contact. If you do not wish to be solicited by phone, call the National Do Not Call Registry at (888) 382-1222.
Only give credit card information to sites with a secure server—one with a web address beginning with https://.
Check your credit history once a year to monitor it for inaccuracies.
Pay attention to billing cycles and check your account statements. A missing credit card statement could mean that an identity thief has taken over your account and changed the billing address.
Tear up pre-screened credit card offers so no one can fill them out in your name. Better yet, call (888) 5-OPTOUT or visit www.optoutprescreen.com, a phone number and website maintained by the three credit bureaus for consumers who do not want to receive these offers.
If your credit report contains negative but accurate information, you need to begin rebuilding your credit history. Start by identifying the unfavorable items in your record. If a temporary difficulty is causing you to fall behind in making payments, offer to pay creditors the charges due so you can clear the account. If the delinquency is more serious, you may need a financial restructuring, which would require negotiating new terms and repayment schedules with creditors.
Many people who are involved in disputes with creditors—or just want to avoid having credit problems escalate into more serious situations—consult credit counseling agencies like the Consumer Credit Counseling Service (CCCS). CCCS counselors can help you prepare a budget and work closely with your creditors on a debt restructuring plan that satisfies both parties. The quality of credit counseling services varies widely and because many agencies are funded by the credit industry, you should not consider them to be consumer advocates. To increase your chances of working with a reputable agency, seek out a nonprofit counselor and check with the Better Business Bureau to see if any complaints have been filed against the agency.
Be especially wary of credit clinics or credit repair companies that promise a quick fix for debt problems. Their exorbitant fees and dubious guarantees distinguish them from legitimate, nonprofit credit counseling services. What’s more, they can further tarnish a credit report because lenders consider you to be a bad credit risk if you work with them. Before you resort to working with such a service, try to get your debt under control yourself. Many lenders and credit card issuers have departments that deal specifically with borrowers undergoing financial hardship. They may be willing to make special arrangements to help you pay off your debt.
If you have a good credit rating, you have the benefits of readily available credit and increased financial flexibility. But if you become indebted, your financial flexibility begins to erode. That doesn’t happen overnight, however, and there are signs that can forecast trouble ahead:
- The amount of your minimum monthly payments on all credit accounts, excluding rent, mortgage, and utilities, exceeds 20 percent of your net monthly income.
- You juggle payments among creditors and consistently pay only the minimum amount required every billing period.
- You have exhausted sources of credit that are immediately and easily available and must rely more frequently on the overdraft credit line on your checking account.
- You are denied new credit. Creditors already think of you as a high risk.
- You are drawing more and more on your pool of financial assets, savings, or other investments that have been set aside for future use.
When a borrower cannot repay money owed, debts can be restructured by negotiation or under the supervision of a bankruptcy proceeding. The bankruptcy process is designed to enable all creditors to receive equitable treatment, while allowing the debtor to restructure or discharge debts and get a fresh start.
Voluntary bankruptcies, including Chapter 11 proceedings (used mainly by business), Chapter 12 (designed for farmers), and Chapter 13 (used mainly by individuals), allow debtors to retain control of assets while they renegotiate debt payments. Voluntary debt proceedings call for the debtor and the creditors to negotiate a repayment plan, which can involve reducing the amounts due, postponing payments, changing interest rates, or a combination of these. Once a court approves the plan, the debtor comes out of bankruptcy with restructured debts. In Chapter 7 proceedings, the court takes control of a debtor’s assets and distributes them to creditors, while the debtor is allowed to keep certain assets. Since the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, it has become considerably more difficult for consumers to file for Chapter 7 bankruptcy (straight liquidation of debt) and more common to file for Chapter 13 bankruptcy (reorganization of debt).
An increasing number of personal bankruptcies involve overextended consumers who have run up substantial balances on credit card accounts and are tired of juggling balances and paying significant portions of their personal incomes on interest. In a 2010 survey of nearly 53,000 individuals receiving bankruptcy-related credit counseling services, the nonprofit Institute for Financial Literacy found five chief reasons for financial distress: a reduction of income/job loss, being overextended on credit, having unexpected expenses, illness/injury, and divorce.
Filing for bankruptcy should be considered only as a last resort, as there are direct costs and the filing may remain on a credit record for as long as 10 years. Opportunities for obtaining credit following a bankruptcy are often expensive and limited. It is best to first try to follow a well-designed plan from a reputable credit counseling agency to help rebuild credit and avoid bankruptcy.
That said, distressed borrowers who think that a bankruptcy filing may be the best way out of financial trouble should consult an experienced bankruptcy attorney who can thoroughly explain the advantages and disadvantages of the process. The American Board of Certification, (877) 365-2221, can provide referrals to attorneys who have satisfied the Board’s standards for education and experience in handling bankruptcy cases.