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Borrowing Wisely

Credit can be a blessing or a curse. It can help you purchase things you might not otherwise be able to afford, such as a house or a new car. But it can also sock you with debt, and that can be a drain on your finances.

Just because a lender is willing to make a loan doesn't mean you should automatically borrow that amount. Here are a few things to consider before taking on debt:

  • How stable is your income?
  • How secure is your job?
  • What are your regular expenses?
  • How much cash do you need on hand each month to feel comfortable?
  • What are your long-term financial goals? For instance, will you be able to afford that dream vacation?
  • Will you still have money on hand in case of an emergency?
  • Will you be able to save money even with the increased debt load

The Costs of Borrowing
Credit costs money. When borrowing, try to get as low an interest rate as possible. For a mortgage, this will be equal to the Prime Rate, which is set by the Federal Reserve. For a credit card, it's the prime rate plus the lender's margin rate (whatever percentage it chooses for a particular card offer, such as 2.5 % for people with good credit or 10 % for those with low credit scores).

Methods to Calculate Interest
Lenders have different ways of calculating interest, and this can have a big impact on how much you'll spend over the life of the loan. It's important to know these methods well enough to identify them in the fine print of a loan contract.

  • Adjusted balance is the amount owed at the beginning of the billing period minus any credits and payments you made during that period. New purchases are not counted.
  • Average daily balance, one of the most common methods, adds your balances for each day and divides that total by the number of days in the billing period. Payments and credits made during the period are subtracted. New purchases may or may not be included.
  • Two-cycle average daily balance uses the average daily balances for two billing periods to calculate the finance charge. Payments and credits will be accounted for and new purchases may or may not be included.
  • Previous balance bases the finance charge on the amount owed at the end of the previous billing period.

The Costs Over Time
The Bankcard Holders of America (BHA) calculated the finance charges on one account four different ways. They calculated a scenario in which a $1000 charge and a minimum payment were made made one month. The following month another $1000 charge was made. Then the entire balance was paid off. They calculated the interest on this four different ways. Here's how the charges differed:

  • Average daily balance method, including new purchases: $33
  • Average daily balance method, excluding new purchases: $16.50
  • Two-cycle average daily balance method, including new purchases: $49.05
  • Two-cycle average daily balance method, excluding new purchases: $32.80

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