Most Americans live on credit. The average debt per US family is $6,270 in 2020 (the total debt for all Americans combined is a staggering $14.3 Trillion of which the total Credit Card debt is $807 Billion)[i]. Credit is not necessarily a bad thing if you know how to manage it. The 3 main categories of credit that most of us encounter during our lifetime are Mortgages (usually related to home), Loans (personal loans, auto loans) and Revolving Credit (credit card debt). Each of these need a quick detailing in terms of their nature and are elaborated below:
Mortgages
Simply put, this is a type of credit used to fund a home purchase. It has been given a special treatment and preferential rates as the underlying asset on which they provide the loan (the home itself) would appreciate or keep its value intact. So, in future if the borrower defaults, the lending agency has a right to sell the property and recover their loan.
Mortgages are typically in excess of $200,000 and may top $1,000,000 in a few cases. As the monies involved are very high, the lender usually has an option to repay it in equal monthly installments that can go up to 360 months.
A mortgage usually requires significant amount of commitment and liquidation of investments. The borrower acquires an asset [ii] whose value will be realized only upon its sale. On an initial glance, it may seem that you would be better off in a rental home rather than making such a commitment. This topic has been discussed in detail in the section Factors Impacting Rent v/s Purchase. It also covers a critical aspect on how much value of the home can you afford.
Home Equity Line of Credit (HELOC)
This is a variation of Home Mortgage where the underlying asset security remains the home. It can be a primary lien [iii] or a secondary lien (in addition to the home mortgage). The borrower has an ability to overdraw an amount when they have a shortfall and can pay it back when the borrower has enough income to cover the shortfall.
The interest that the borrower will have to pay is usually calculated as a simple interest on the daily outstanding balance that was borrowed. If the borrowed amount continues beyond the statement period, then the borrower will be required to pay a minimum payment usually within 15 days of statement date (like credit cards).
The interest rates charged by the HELOC lenders are usually higher compared to Home Mortgages and lower than personal or revolving credit interest rates. HELOC lenders also provide an introductory rate for the first year after account is opened (usually this will be lesser compared to Mortgage rates).
This can be used as a very powerful tool to maintain low balances in your short-term deposit accounts at a very low cost. I will also detail out how a HELOC can be used to reduce the overall interest payments (even if their interest rates are higher than a mortgage) and pay off the home quicker. This scenario will be illustrated with an example in Making the most of your HELOC. Note that this strategy will work wonders for you if you have sound financial habits but will be disastrous otherwise.
Loans
Loans are usually provided against no guarantee or for a purpose of a depreciating asset (like a car). As there is no guarantee that the lending institution will be able to recover their money in case the borrower defaults, such loans carry a higher interest rate. Such loans can be for a specific objective like auto loans, education loans or personal loan.
Revolving Credit
This is most common form of loan that carries the highest interest rates and at the same time helps immensely in managing one’s cash flow. The most common form of revolving credit is Credit Card purchases.
Credit card users can make purchases up to a maximum amount approved by the issuing lender which is also referred to as credit limit. The amount is usually due 15 days after the statement date so if you make all purchase 1 day after the previous statement then you will get 45 days to repay the amount.
The credit card companies usually ask you to pay any amount between minimum payment and the outstanding balance at the end of statement period. Here lies the trap – if you are used to making minimum payments (or any amount lower than the statement balance), the credit card companies charge you up to 22% interest on the remaining due balance. This is the most expensive kind of loan one can avail and needs to be avoided in all circumstances.
[i] Source: Federal Reserve Bank of New York
[ii] assets represent value of ownership that can be converted into cash
[iii] a right to keep possession of property belonging to another person until a debt owed by that person is discharged.
