A good way to better understand different types of credit is to consider them in regard to whether they are short-, medium-, or long-term. The time frame over which a type of credit should ideally be repaid determines the type of purchase that credit is best suited for. Problems arise for borrowers when debt that is meant to be short-term is carried over an extended period of time. In this section, we’ll look at the most common types of credit and their pros and cons.
Short-term credit can take a variety of forms. What characterizes these forms is they are designed for small purchases and meant to be paid off relatively quickly. While they can provide convenience for the consumer, generally, they have higher interest rates than medium- and long-term credit, which can make them a financial burden if balances are carried over time.
Payday Loans This type of loan is typically characterized by a very high interest rate and a short loan period. It works by having the borrower write a check to the lender that is post-dated to the end of the loan period (usually the borrower’s next payday). The borrower then receives money in the amount of the check minus the interest on the loan. At the end of the loan period, one of three things happens: the borrower repays the loan, the borrower defaults and the lender cashes the check, or the borrower rolls over’ the loan. Rolling over’ the loan means the borrower renews it for another two-week period and pays another round of interest. This last scenario is the most common. One industry-funded study found that 75% of payday loans are rolled over at least once and 40% are rolled over five or more times.2 The standard condition that the loan must be paid in full, combined with the shortness of the loan period and the borrower’s usually challenged financial situation, greatly favors this outcome.
The very high interest rates that payday loans have, relative to other forms of credit, should make them a credit source of very last resort, if one at all. To understand just how high their rates are, let’s compare them with those of other common types of credit. A typical payday loan might charge $15 to $30 for every $100 borrowed over a two-week loan period.3 That’s 1530% interest. At first glance, that may seem to be no higher than what many credit cards charge. Consider, though, that this 1530% interest is only for a two-week period. If you multiply that loan period out to a year, which is the standard period that banks and credit cards use to calculate interest rates, that 1530% interest jumps to 390780%.3 This is the actual annual percentage rate (or APR) on the loan. That’s very expensive credit indeed.
Rent-to-Own Plans Although it may not be apparent at first, rent-to-own plans are also a form of credit. In a typical rent-to-own plan, the consumer takes possession of merchandise such as furniture or an appliance in exchange for weekly or monthly rent’ payments. At the end of a specified period, usually 12 to 18 months, the consumer assumes ownership of the items. In essence, this is the same as purchasing on credit, because the consumer assumes possession of the merchandise upfront and agrees to pay off the cost of the item, plus interest, over time. However, because this arrangement is not marketed as a form of credit, rent-to-own stores are not required to disclose effective APRs to consumers. When you do the math, those APRs are typically 100% and may run as high as 300%.4 These plans may be appealing to consumers whose other options are limited, but you’ll probably end up paying a lot less in interest if you use an installment loan to make the purchase instead.
Credit Cards A credit card account is an unsecured line of credit in which the balance fluctuates, depending on what is charged and paid toward that account each month. Even though it’s possible to carry a credit card balance for years (and, of course, many people do), ideally, this type of debt should be repaid fairly quickly, which is why we consider it a form of short-term credit. Although credit cards can be useful and convenient, it’s tempting to make impulse purchases when you can defer paying for items. Even small purchases can start to add up and, before you know it, you’re in over your head in debt. It’s also tempting to pay just the minimum due each month, which can keep you paying on a balance for a long time. ( Learn what to look for when choosing a credit card account.)
Pay Advances for Service Members Advance Basic Pay is an interest-free loan, offered by the military, that is designed to help service members cover the costs associated with relocation. These are secured loans that use a member’s future earnings as collateral. Members may draw up to three months basic pay, which must then be paid back over the following 12 months through payroll deductions, although in certain circumstances, the payback period may be extended to as much as 24 months. Your base’s Pay and Financial Office can provide more details specific to your situation.
Medium-term credit can be loosely defined as credit you pay off in 13 years. It is designed to help make larger purchases such as a car, travel, furniture, or home improvements affordable.
Medium-term credit falls into two basic categories: secured and unsecured. A loan for a new car is an example of a secured loan. This means the car acts as collateral for the loan amount. In general, secured loans are less risky for lenders, which usually results in a lower interest rate for the borrower. Usually, CDs or other savings or holdings can also be used as collateral in order to receive a lower interest rate.
Community Bank Loans Community Bank offers medium-term loans that address a variety of financial needs. These can include expenses associated with starting a family, personal travel, a new car, or relocation. Community Bank’s Signature, New and Used Car, and Vacation Loans are all forms of installment credit. This means they are borrowed in a lump sum and repaid through regular payments over a predetermined number of months.
Line of Credit Not all medium-term credit takes the form of an installment loan. For example, Community Bank’s Line of Credit is a revolving, unsecured loan that can be borrowed in stages, rather than in one lump sum. However, unlike credit cards, it is intended for larger purchases of $1000 to $10,000. Community Bank’s Line of Credit is ideal for situations in which you are uncertain of the amount or starting date of the loan. You may borrow any amount up to the limit you have been approved for, and you are only charged interest on the actual amount for which you write the check. If you need to increase the amount of the loan at a later date, you may borrow from your remaining available balance at any time. Community Bank’s Line of Credit gives you the low, fixed rates of our Signature Loan with the flexibility of a credit card.
Long-term credit can be defined as credit intended to be paid back over a period of time longer than three years. Prime examples are home mortgages and education loans. Usually, the amount of these loans is sufficiently large that the borrower needs a period of time longer than three years to repay the loan. In the case of a large purchase, such as a house, loan periods can last decades. In addition to having interest rates that are generally less than those of short-term credit, long-term credit offers tax advantages. For instance, in most cases, the interest paid on home and education loans can be deducted from federal income tax. For these reasons, if you have extra money that you can allot toward paying down debt, put it toward short- and medium-term debt first, while paying the minimum on long-term debt.
Rather than helping you achieve financial goals, overuse of credit can become an impediment that limits your options. Fundamental to avoiding pitfalls is using credit wisely. Before buying on credit, ask yourself if you really need to make that purchase immediately. If it’s a discretionary purchase, consider saving for it first. You’ll pay less in the end by avoiding interest, keep more credit available for emergencies and non-discretionary purchases, and keep your credit score higher, possibly making the credit you use less expensive.
2 Robert Mayer, "One Payday, Many Payday Loans: Short-Term Lending Abuse in Milwaukee County," <http://lwvmilwaukee.org/mayer21.pdf>, accessed on October, 7, 2009.
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