Borrowing, Credit, and Debt

Why people borrow

People usually borrow because they want something that costs more than their current income and savings can cover, such as a car, a house or college tuition. They also borrow to handle an emergency, to keep their savings intact while they buy something, or for convenience, the way a credit card saves you from carrying cash.

Borrowing creates a personal liability, or debt: money you owe. A loan has to be repaid with interest, and the interest rate and repayment terms depend on the lender, the type of loan, the amount you borrow and your credit history.

Collateral changes the rate. A loan used to buy something that can serve as collateral, such as a car or a house, is a secured loan. Because the lender can take the car or house if the loan is not repaid, a secured loan is less risky to make, and it typically carries a lower interest rate than a general consumer loan, which is unsecured.

Who lends

Financial institutions such as commercial banks and credit unions take deposits from individual savers, businesses and other organizations, and they use those deposits to make loans to consumers, businesses, nonprofits and government entities. The money in your savings account from the savings lesson is part of what a bank lends to its next borrower.

Credit card companies, retail stores and mortgage lenders lend to consumers too. So do alternative financial services, such as payday loans and instant tax refunds (loans against a tax refund the borrower expects to get). Check-cashing services also count as alternative financial services, though cashing a check is not itself a loan.

Consumer protection laws set rules for all of them. Lenders must communicate credit terms to borrowers clearly and explicitly. The laws also govern the tactics lenders use to collect debts, and they prohibit discriminatory lending practices.

How a lender decides

Every loan carries the risk that the borrower will default, meaning not repay it. So lenders prefer to lend to people who pose less risk: people with low existing debt, high income and savings, and a history of repaying loans on time. Lenders willing to lend to higher-risk borrowers, including alternative financial services, typically charge higher interest rates.

To judge your creditworthiness, a lender collects information about your income, your savings and the debt you already have. It also looks at your credit report, which details how you have used credit in the past.

Credit reports are created by credit bureaus, also called credit reporting agencies. They collect information each time you deal with a financial institution: applying for a credit card, getting a bank loan, making (or missing) a payment. Opening a bank account, such as a savings account, can leave a record too, because banks often check an applicant's history with a reporting agency first. A credit score is a number calculated from the information in your credit report that sums up your past use of credit, and lenders usually get one along with the report. Lenders are not the only ones who see your report. It can be shared with potential employers, potential landlords, insurance companies and government agencies.

When debt becomes a problem

Borrowing for a car you need to get to work can make sense. But high levels of debt harm your finances, because every loan payment is income you cannot save or spend on anything else. Larger debts and higher interest rates both mean higher monthly payments.

Borrowers run into trouble for a variety of reasons. Some lose income. Others take on monthly payments larger than they can afford. When debt becomes unmanageable, the consequences can include property seizures, such as a car taken back by the lender. People in that position may be able to get debt management assistance. In some cases a borrower seeks bankruptcy, a legal process that eliminates some debts and helps the borrower set up a repayment plan for the others.

Managing debt and credit

Keep your credit score high. Pay bills on time, pay off existing debt, and minimize your use of credit cards. A high score helps you qualify for better terms the next time you borrow.

Seek better terms. Lower interest rates and lower fees are worth shopping for, so compare the terms different lenders offer before you sign. On a major purchase like a home or a car, make a down payment: pay part of the cost up front with income or money you have saved. You borrow less, and you can get better terms.

Repay high-interest debt as quickly as possible. Credit card debt is the classic example. A card's APR (annual percentage rate) is its yearly interest rate, so one month's interest is about the balance times the APR, divided by 12. A $3,000 balance at 24% costs about 3,000 times 0.24, divided by 12, which is $60 of interest every month. If a payment does not cover the month's interest, the unpaid interest is added to the balance and the debt grows instead of shrinking.