Learn about Debt and the Cost of Using Credit

Debt versus credit

“Credit” refers to any financial tool that allows you to pay for something and then pay it back over time. “Debt” is the financial obligation that credit creates—it’s the money you’re required to pay back.

If you use credit, then you will have debt that you need to pay back.

The cost of using credit

No matter what type of credit you use, it will almost always have a cost to it. And that cost can be high. Not only do you have to repay the money you borrow, but you also will pay added charges for the convenience of using credit.

Fees

Almost all loans and many credit cards have fees. Fees are specific set amounts that get charged at certain times.

Here are two common fees you’ll encounter:

• A loan origination fee is a fee charged when you first get a loan. It usually amounts to a small percentage of the amount you borrow. So, if you take out a $5,000 and it has a 1% origination fee, you will pay $50 to get the loan.
• Any credit card or loan will have a late fee, which is a fee you get charged if you don’t make the required payment by the due date. Late fees can be expensive. For example, the average credit card has a $40 late fee.

When fees apply, they increase the debt that you need to pay back. For things like loans, some fees will immediately increase the balance you owe before you ever make a payment.

Interest rate

Any type of credit you use will always have an interest rate. This is a rate that gets applied to your balance every billing period. Part of each payment you make will go to cover the interest charges added for that month.

Most interest rates are listed as an annual percentage rate or APR. This rate can be used to find the amount you’ll pay for a type of credit over one year.

So, let’s go back to our example of the $5,000 loan. If the APR on the loan is 5%, then in the first year you have the loan you will pay $250 in interest charges.

Now compare that to a credit card. If you have a balance of $5,000 on a credit card with an APR of 20%, you’d pay $1,000 in interest charges over one year.

Smart Money Tip: Avoid debt with high interest rates

As you can see from the example, credit cards have much higher costs than most loans. That APR of 20% isn’t made up—many credit cards have that rate or an even higher rate.

There are ways to avoid all those credit card interest charges, which we’ll teach you in the next lesson. But if you’re looking at different types of credit, always go for the one with the lowest interest rate possible.

You also want to avoid loans that have extremely high interest rates. For example, payday loans that promise fast cash with no credit check. They have interest rates of over 400%! That’s why it’s best to avoid them.