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Consumer credit, put simply, is the ability to pay for items with credit instead of cash, which usually means borrowing money and paying it back over a period of time. Credit cards, student loans and mortgages are all examples of consumer credit in action.
Taking on credit such as a credit card or loan can offer opportunities you may not have otherwise, whether it's the ability to buy a home or earn credit card rewards to get more value from your purchases. Lenders will take a look at your borrowing history when determining whether to offer you credit (and how much to charge you for it), and your ability to responsibly manage credit accounts will be the most important part of that decision.
Here's how you can best make use of consumer credit, and how you can limit exposure to its potential pitfalls.
What Are the Major Types of Consumer Credit?
There are two primary categories of credit that a consumer may have access to. They are:
- Revolving credit: A revolving credit line provides a borrower with a total amount of money they can draw from in the form of a credit limit. They'll repay only the amount they choose to borrow. Credit cards and home equity lines of credit (HELOCs) are types of revolving credit, which is sometimes also referred to as open-end credit.
- Installment credit: Unlike revolving credit, installment credit provides a borrower with a set amount of money that the borrower then repays in fixed installments over time. Examples of installment credit, or installment loans, include student loans, auto loans and mortgages.
What Are the Main Advantages of Consumer Credit?
These are the advantages you can expect when you use consumer credit such as credit cards and loans:
- Practicality: Credit cards offer the ability to make purchases without needing to carry cash. And unlike a debit card, credit cards allow you to pay off charges in installments, which can make big purchases more affordable. Ideally, you'll repay all charges as fast as possible to avoid paying a lot of interest on your purchases.
- Opportunity to achieve life goals: Credit gives you the ability to buy a car, a home or other large purchases you may not be able to pay for in cash.
- Credit score growth: When you keep debt balances low and pay credit card and loan bills on time, your credit score will likely increase. That comes with a huge variety of benefits, including the ability to qualify for low-interest loans, in bigger amounts, in the future.
- Utilities without deposits: With a good credit score, you may be able to avoid having to pay a deposit before setting up electricity, cable, phone or water service at a new home. Cellphone companies may also require a deposit if you have insufficient credit history or a low credit score.
- Credit card rewards: Another advantage of strong credit is access to rewards credit cards, which offer points, miles or cash back when you make certain purchases. Used wisely, these cards can lead to big savings. But it's imperative to pay off your bill in full each month in order to prevent interest accrual from eating into those savings.
- Protection from fraud: With a credit card, you're protected by law from paying more than $50 if fraudulent charges are made using your card. Several credit cards even offer zero-liability protection, which means you're never liable for unauthorized charges. Plus, credit cards often come with special features that make fraud less likely, such as the ability to lock your card quickly on the issuer's website or app if the card is lost or stolen.
- Purchase and return protection: Credit card issuers may also, depending on their terms, replace an item you've bought with the card if it's stolen, lost or damaged upon arrival.
What Are the Disadvantages of Consumer Credit?
While there are few disadvantages of credit when you manage your accounts responsibly, it's important to be aware of certain pitfalls you could encounter as you work to build a positive credit history.
- Risk of mismanaging debt: With access to a revolving credit line, there is a chance you could borrow more than you can feasibly repay. Taking out a loan also opens up the possibility that you will be unable to fit your new monthly payment into your budget. It's crucial to use a calculator—such as one for personal loans or mortgages—to understand how much you'll have to pay per month, and for how long, before taking on credit.
- Deceptive interest rates: Double-check before applying for a credit card or loan to ensure the rate you've seen advertised is actually the rate you'll get. Yours will likely be dependent on your credit score, income (especially debt-to-income ratio) and other factors—or the promotional rate you've seen may only be available for a limited time.
- Fees and penalties: Loans and credit cards generally both come with not only an interest rate, but fees for infractions such as paying late. Check the product's fee schedule for a full overview, and be sure you'll be able to make all your payments on time. You may also be required to pay an annual fee on a credit card; before you apply, determine whether you'll get enough use of the card to justify the yearly fee.
- Risky loan products: There are some loans that have the potential to create a debt cycle. In general, avoid payday loans, which come with exorbitant fees and interest rates, and opt for alternatives instead.
- Billing errors: You may encounter errors such as inaccurate application of a payment to your account. Check your credit accounts regularly for accuracy, and keep an eye on your credit report to ensure there are no erroneous instances of missed or late payments. However, know that if errors do occur, you can dispute them with the lender or the credit bureau on whose report the information appears.
- Abusive collection practices: If you fall behind on credit card or loan payments, your account may be transferred to a collection agency. Familiarize yourself with your rights, such as your right not to experience harassment, threats or lies from the company during the debt collection process. That will help you respond appropriately if these occur.
How Credit Protection Laws Help Consumers
The Consumer Credit Protection Act
This law, first passed in 1968, now incorporates several other statutes that prevent discrimination and ambiguity in lending. One of the original elements of the legislation regulates advertising of credit products and compels lenders to disclose the full cost of a loan. The law also bans demographic information such as race, sex, marital status or religion from affecting your credit score or borrowing options.
The Fair Credit Reporting Act
This law is part of the Consumer Credit Protection Act. Since your credit report and score are so important to your financial life, the Fair Credit Reporting Act helps ensure you have easy access to that information. It states that all consumers can check their credit reports for free once per year from each credit reporting agency. (You can do this at AnnualCreditReport.com.) It also gives you the right to learn whether negative information in your credit file affected an application for credit or insurance products or employment.
Can Consumer Credit Counseling Services Help?
If you take on too much debt and aren't sure how to get out from under it, you can turn to nonprofit credit counseling agencies such as the National Foundation for Credit Counseling (NFCC). Certified credit counselors help consumers build a budget, develop debt payoff plans and provide assistance understanding specialized financial products like student loans and mortgages. The first consultation is typically free. You can use the NFCC's website to search for a reputable credit counselor in your area.
How to Use Credit Wisely
Consumer credit is a powerful tool to build your financial well-being. While there are potential pitfalls, such as taking on debt you're unable to repay, there are also many resources available to help you identify the right credit products for your situation. As you begin to build your credit history, it's important to monitor your credit report and score, which you can do for free through Experian, to see where you stand. Remember that you are in control of your experience with consumer credit. Reliable help, such as through credit counseling, is always there if you need it.