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How to use credit responsibly

While credit is very important to the economy, its abuse is harmful.

Credit is extended with the faith that borrowers will repay the debt.

Goods and services are provided on credit with the expectation that they will be paid for with money in the future. Credit makes commerce more convenient. When credit is abused, everyone loses.

Credit abuse increases the cost of credit to everyone.

If you charge it, make sure you can pay it off

One should never use credit to purchase things for which one will not be able to pay in the future. Many impulse purchases are made on credit with little thought given to how the debt will be repaid in the future. If one calculated the true cost of goods bought on credit, one would have second thoughts about making the purchase in the first place. Here is an example: a new television flat-screen HDTV model retails for $5,000.

If purchased on a credit card with a 12% annual percentage rate (APR) compounded daily, and with minimum monthly payments of $166 paid over three years, it winds up costing over $5,980. Is it worth almost $1,000 more to have it now (furthermore, the retail price in 3 years will probably drop)? That is like going into a store that advertised "SALE—ADD 20% TO EVERY PURCHASE."

Credit's purpose is to make it easier to get things

Credit is designed to improve financial transactions. When used responsibly, it does just that. Certainly, there are things we need now for which we do not have all the cash. As long as we understand the cost of convenience (interest and finance charges) as well as having the ability to make the payments until the debt is repaid in the future, then credit may be appropriate if cash is not currently available.

The key is in knowing that the cash will be available. This allows us to purchase homes, automobiles, and other goods and services for which it is too impractical to wait until we save all the funds needed.

When used properly, credit can be a great cash management tool. When abused, it can lead to financial disaster. The cost of credit can be greatly reduced by paying off balances promptly. The longer you take to pay off a credit balance, the more it costs you.

Dive Deeper: What credit is, why you need it, and how to know if you're creditworthy

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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