For most of us, loans are a necessary part of life. Building credit responsibly ensures that when we need a little extra cash or funds for a significant purchase like a car or a home, we get fast approval with the very best terms available. While it is often easy to obtain credit regardless of your circumstances, there are differences between the types of borrowing available and the amount of interest you’ll be charged.

It’s important to fully understand how credit works, so we will break down the subject to give you clarity.

Credit Score

As we have established, a good credit score is important because it helps creditors determine the level of risk someone carries. This information will determine if credit will be extended, the type of loan offered, the interest rate, and potentially the repayment period.

Having a high credit score is beneficial because it makes it easier to obtain loans, rent an apartment, lower your insurance premium, and most importantly keep interest payments manageable. Many employers even check your credit score before making a hiring decision.

Who determines a credit score?

Credit bureaus or credit reporting agencies are responsible for collecting and maintaining consumer credit records, which they then sell to other businesses in the form of a credit report. The big three companies that are most important to consumers are Equifax, Experian, and TransUnion.

Each of these bureaus produce credit scores created by Fair Isaac Corporation known as FICO® Scores. These widely accepted credit scores are calculated based on the following information:

• Balances outstanding
• Length of credit history
• Strength of repayment history
• Applications for new credit
• Types of credit already held, i.e. mortgages, car loans, credit cards

A credit score can range between 300-850; with a score of over 700 being considered ‘good’ and over 800 ‘excellent’. The average credit score in the U.S. is currently 687.

It is important to remember that you have a right to view your credit report once a year at no cost, and it is possible to order them each year through AnnualCreditReport.com. You are also allowed to request a free report if you are denied credit. Regular reviews of your credit report allow you to see what lenders are seeing and gives you the opportunity to take any necessary action to improve your score. Although a credit report won’t contain your credit score, it’s always important to make sure the information in it is completely accurate. There are ways to get your credit score for free by using apps such as Credit Karma.

Credit Cards

Most of us are familiar with credit cards and how they work. Credit cards operate through an agreement between the store, bank, or credit union, who issues the credit or loans, and the consumer or borrower, who will pay for goods and services with those funds, for a stated interest rate. A survey carried out last year showed that 68% of Americans hold credit cards.

The main benefit of credit cards is in their convenience. Compared to paying for goods and services with debit cards and checks that immediately disappear from your bank balance, credit cards provide a short-term loan that can offer relief from a budget that is short income, particularly if hit by a surprise expense.

There are some disadvantages to credit cards too. Having access to extra money when we’re running low in our bank accounts can lead to making unnecessary or expensive purchases or worse, spending money isn’t in our budget. If we take on too much debt, even our minimum payment may become too much for us to handle. Having an emergency fund and aiming to pay off credit card balances in full each month should be a priority for a healthy financial situation.

There are many different kinds of credit cards available in the U.S., with varying terms and conditions. Some can levy rates of up to 30% if a payment is missed and so it’s easy to see how this can escalate quickly for many people, leaving them in financial difficulty. In total, credit card debt in the United States amounted to approximately $0.78 trillion in the second quarter of 2017.

The Difference between APR and Effective APR

There are two main types of interest rates applied to credit cards:

Annualized Percentage Rate or APR is a type of interest that is calculated over a set period of months, usually twelve. Paying 1.5% interest on a credit card each month means that your nominal APR works out to 18%.

The amount you pay when compound interest and fees have been added is known as Effective APR. This means that although your nominal interest rate is 18%, you might be paying closer to 23% with charges added.

The Truth in Lending Act governs the “informed use of consumer credit” — it requires lenders to disclose all the various terms of the credit / lease so that consumers can more easily make an informed decision.

How Credit Card Interest Is Calculated

Although the APR is useful when it comes to comparing credit card deals and also gives you a rough idea of how much you will have to pay over time, it isn’t entirely accurate. This is because credit cards don’t charge interest just once each year, they are continually charging interest on balances every day. This daily interest calculation is known as the daily periodic rate or DPR.

You can calculate your DPR by dividing your card’s APR by the number of days in the year. Mostly, banks divide by 365 although there are some who divide by 360, which is worth bearing in mind.

Example:

Say your credit card’s APR is 12%. To discover your daily periodic rate, divide the APR by 365, which in this example works out to 0.03%.

When a bank charges interest based on the DPR, they calculate the figure based on the average daily balance owed on the credit card. This is obviously because your credit card balance is more than likely to fluctuate throughout the month as you make purchases or partial payments of the balance owed.

The way you calculate what your average daily balance is as follows:

Say your credit card’s APR is 12%. To discover your daily periodic rate (DPR), divide the APR by 365, which in this example works out to 0.03% or 0.0003 as a decimal.

When a bank charges interest based on the DPR, they calculate the figure based on the average daily balance owed on the credit card. This makes sense because your credit card balance is more than likely to fluctuate throughout the month as you make purchases or partial payments of the balance owed.

The way you calculate what your average daily balance is as follows:

• Say for example there is $1,000 owed on the credit card at the beginning of the month and 15 days later, another$2,000 is added to the balance calculation. (New purchases have a at least a 21 day grace period and will not have interest charged during those first 21 days, see your card agreement for details pertaining to your card.) Now you owe $3,000.
• The card issuer multiplies each balance by the number of days you carried it on account and adds them together before dividing it by the total number of days in the month:

($1,000 x 15 days) + ($3,000 x 15 days)

= $60,000/30 days

= $2000 average daily balance

• Finally, to complete the calculation of interest charged in one month, you multiply your daily average balance by the daily periodic rate of interest above, as follows:

$2000 x 0.0003 x 30 days =$18

How Does Only Paying the Minimum Payment Impact Your Credit Score?

If you only see a small amount due as a minimum payment on your monthly credit card statement, it can be very tempting to pay only that amount and spend the rest elsewhere. Although paying just the minimum payment is within the terms of your credit card agreement, you will end up paying more in interest the longer it takes to pay off the balance. Also note, too much outstanding debt and holding balances close to your limits will negatively impact your credit score. Every month your credit card company will report back to the credit bureaus on your activity with the account.

Late Payments and Your Credit Score

Making a late payment from time to time is really no big deal, but making a habit of it will become a big problem. Late payments lead to negative comments on your credit report from lenders. It will also cause your interest rates to rise for existing variable rate credit and future credit offers.

Rectify late payments before a collection agency is used to collect payment from you. If an agency is already calling, try to work directly with the lender to clear your debt. Negotiate new terms for repayment, but make sure you can afford the new arrangement.

Improving Your Credit Score

Here are some simple things to look for on your credit report and items to correct:

• Double check your name, make sure it isn’t someone else with a similar name. It is common for juniors and seniors with the same name to end up on each other’s report.
• Make sure there are no unfamiliar accounts open in your name.
• Contact credit bureaus and creditors to clear any negative comments.
• If you have had a history of late payments, start asap paying on time.
• If you have had late payments in the past but you have been good for the last 12 months, contact the creditor to remove any negative comments and request an improved interest rate.
• Make sure no debt appears twice, for example, a creditor debt and a collections debt for the same account. Contact the creditor to rectify delinquent accounts if possible.
• Avoid any foreclosures or repossessions of assets purchased with a loan. These serious items will cause your score to plummet 150 to 200 points and future interest rates to skyrocket. The higher your starting score the more it will fall.

Check your report once a year to find any issues or evidence of identity theft. Credit can be used to your advantage if learned to use it in the right way. Avoid traps of overspending, make sure to have an emergency fund of 3-6 months of expenses, and live below your means if you want a healthy financial life, free from stress.