• Types of Credit
• How Much Credit You Can Afford?

Types of Credit

Credit cards, loans and other types of credit are convenient to use, make managing your money easier, and can be especially useful during emergencies. Credit makes it easier to pay for large expenses such as cars and home improvements, and a mortgage can put you in a home without needing cash for the entire purchase price.

Credit is a powerful tool

But credit is also a big responsibility. When you use credit improperly, it can lead to unmanageable debt and financial crisis. The more you know about credit, how to manage it and the warning signs when you may need help with managing credit, the easier it is to use this powerful tool wisely.

Types of Credit

You can obtain a loan for a specific purpose, such as financing a new car, paying college tuition and buying or renovating a home. You can get a debt consolidation loan, which combines all current debts from various creditors into a single reduced-interest payment plan. And you can get a credit line linked to your checking account that gives you bounce-proof protection if you write a check for more than what you have in your checking account.

Loans are generally divided into two types: secured and unsecured. A secured loan is a loan which is guaranteed by collateral of some kind. Collateral is an item of equal or greater value than the amount of the loan, such as a car, a home or a cash deposit. An unsecured loan is not guaranteed by anything.

Credit cards are perhaps the most common type of personal credit. Using a credit card is like getting a loan. Every time you charge something, you're borrowing the money until you pay it back. If you decide to pay the money back over time, the credit card company adds finance charges to your account that you must pay along with the purchase amount.

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How much credit you can afford?

If the lender is unable to collect on the loan, whether secured or unsecured, there are consequences for the borrower. Defaulting on a loan is serious business, and can impact your credit rating, resulting in an inability to take out new loans, and in more serious cases may lead to legal action.

Set a realistic budget... and stick to it!

That's why the first step in using credit wisely is figuring out how much credit you can afford to take on. You need to take a long, hard look at your current and future financial situation before you take on any new debt. As part of this analysis, you should look at your debt ratio and set a realistic budget for debt repayment.

Debt ratio

Debt ratio looks at how much you owe compared with how much you earn. It usually gives a clear picture of your financial well being. The lower your debt ratio, the more you have left over to save or spend on other things.

Your debt ratio is the percent of your monthly take-home pay that goes to paying debts and monthly obligations. You calculate it like this: Take the amount needed to repay debts each month, including rent or mortgage, and divide this by your take-home pay (your net pay after deduction of tax).

Many experts recommend that no more than 15-20% of your monthly household take-home pay (excluding rent or mortgage) should be used to pay debts and make loan payments. Furthermore, no more than 40% of your monthly take-home pay should go to paying all debts, including mortgage payments.

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