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Understanding Consumer Credit

Saturday, February 23, 2013

So, you want to renovate your kitchen and have applied to your bank for a personal loan to pay for the materials and labour. You’re also considering buying a larger refrigerator from the furniture and appliance store on hire purchase. To pay for the groceries you’ll be putting in the fridge, you’ll be using your credit card. 



The common denominator linking all these purchases is that they are forms of ‘consumer credit’, which is a means of obtaining cash you don’t have to pay for non-investment related goods and services by agreeing to repay in the future. It is referred to as ‘consumer credit’ (or ‘consumer debt’) because is used by consumers -- individuals who buy items that depreciate (or diminish in value) fairly quickly like computers, motor vehicles, furniture and vacations, or persons who use access to credit to pay for regularly incurring expenses like utility bills. The one thing most types of consumer credit have in common is they typically come at a cost. That cost is ‘interest’, a percentage of the total credit amount you’ve obtained added to the original amount, so you pay back more than you initially borrow. With so many types of consumer credit now readily available to us, it’s easy to get confused. Let’s look at the three most common forms:



Personal loans from banks and financial institutions like credit unions are a form of ‘closed-end credit’ in which you apply for cash for personal purposes. The amount you borrow (the principal) is paid off at a fixed interest rate in fixed amounts (installments) over a specified period of time. Personal loans are useful if you require a large amount of money you either don’t have or prefer not to spend. Loan interest rates are usually lower than credit cards and hire purchase so it’s possible to save money over the life of the loan. However, remember that loans are generally inflexible, with a fixed payment due on a specific date each month. It is also wise to shop around for the best interest rate.  Credit unions, for example, typically offer lower rates than commercial banks so, in the long run, you repay less.



Credit cards are the most common form of ‘open-ended revolving credit’.  You apply to a bank for a line of credit, which simply put, is the total amount you are ‘borrowing’ with the flexibility to use as little or as much as you need, paying interest on only what you use. The biggest advantages of credit cards are their ease of accessibility to ‘borrowed funds’, repayment flexibility, and they are especially useful for smaller payments. However, credit card interest rates are typically higher than on personal loans so it’s always wise to pay off all or most of your monthly balance to avoid excessive interest. It’s never a good habit to pay only the minimum monthly payment because you may end up in a situation where mounting interest places you out of your depth in credit card debt. 



Hire purchase is a form of ‘installment sales credit’ offered by stores for purchasing items. It’s basically a store loan which you pay back in fixed installments with added interest over a specified period. It’s called ‘hire’ purchase because, in essence, you are ‘hiring’ what you buy without actually owning it until the original price plus interest is repaid. The store also has the right to ‘repossess’ the item if you fall behind on payments. While hire purchase is convenient for purchasing items like furniture, appliances and electronics, the interest charges are usually substantially higher than that of bank loans. So before you make a purchase, find out all the fees and charges and work out what the total cost after repayments will be.  You might be surprised at how much more you’ve paid over the original price had you paid in cash.


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