3 Common Misconceptions about Types of Credit

A better understanding of types of credit you can hold makes it easier to manage your debt.

Managing debt successfully takes careful planning and consideration, both before you get a new line of credit and as you budget while paying of a debt. The types of credit you hold has a significant impact how how easy it is to repay what you owe. Before you apply for a new debt, whether it’s a credit card or a loan, make sure you have room in your budget to afford the debt:

  1. Loans: Will the new debt payments increase your debt-to-income ratio to higher than 36 percent?
    1. You can use a debt-to-income ratio calculator to compare your monthly debt payments to your monthly income.
    2. If your ratio would be higher than 36 percent with the new payments added in, then you should pay off debt before you apply for the new loan.
  2. Credit cards (open credit lines): Will a new credit card bill increase your monthly credit card debt payments above 10 percent of your monthly income?
    1. Calculate 10 percent of your monthly income. If you bring in $5000 per month, then your credit card payments should never exceed $500.
    2. If you’re already spending up to 10 percent of your income, pay off some credit card debt before you open the new credit line.

Things to look out for when applying for new credit

Be careful when you apply for a new credit line or loan that the terms are fair and not set against your favor. For instance, some installment loans give you the option of paying interest-only for a period of time. However, this creates 2 challenges:

  1. When the payments increase to start paying off the principal (original debt owed), you will need to adjust your budget.
  2. By the time the full payments start, your debt may have increased significantly.

That’s why it’s important to always check your Truth in Lending Disclosure Statement. This document tells you everything you need to know about a new debt. That includes everything from total interest charges to the number of payments it will take to eliminate the debt. Always read this document carefully to make sure you understand the terms before you sign.

As you read through the statement, make sure to check for things like penalties for early repayment and whether the required payments are less than the interest accrued each month. Early repayment penalties can make it tough to pay off a debt even if you aren’t struggling. Meanwhile, if a loan amortizes (adds interest charges) faster than you pay off the debt, it’s not a good loan and you should look elsewhere for financing.

How interest really applies to revolving credit

The last point in the video about revolving credit and interest charges is an important distinction. If you start the month with a balance, then interest charges are applied at the end of the billing cycle to any debt you accrue during that month. But if you start the month with a zero balance and then pay off accrued debt by the end of that billing cycle, no interest charges are applied.

This means you minimize interest charges by starting and ending each billing cycle with no debt. And don’t worry – you don’t damage your credit score by eliminating your debt in-full. Credit utilization measures the total amount of debt you have. It should be less than 30 percent to maximize your credit score. However, there is no minimum limit. If you maintain zero balances overall even though you use credit regularly, this is the best thing you can do for your credit score.