Credit Demystified – Chapter 1, Section 1: Terminology

I am, admittedly, quite math-phobic. If I see too many numbers or even sense that I might be required to perform the most basic math calculation in front of people, my mind has a way of shutting down and refusing to restart for several hours. If you’re like me, rest assured. I’ve made every effort to avoid you having to confront your math phobia in public today.

Still, there are a few concepts you must have a basic understanding of before the following material will make any sense. And since that’s the whole point of this exercise — to make sense of the gobbledygook that is Everything Credit — let’s make sure to lay the groundwork. As non-threateningly as possible, of course.

I’ll return to many of these basic concepts later in this guide to develop them further and provide greater detail.

Borrower – that’s us. The little guys. The people buying cars, and houses, and using credit cards.

Lender – that’s them. The banks and the mortgage brokers and the credit card companies.

Principal – the core amount. Often refers to a loan and in that context the principal is the amount borrowed. For instance, let’s say you take out a loan to buy a car. The purchase price of the car is $18,000 and you have no cash so you borrow the full $18,000. In this case, your principal is $18,000.

Down payment – cash you pay out of pocket to reduce the amount borrowed (the principal). Again, this term refers to loans. Using the same car loan example, let’s say you have $2,000 cash saved for a new car. Your $2,000 is the down payment. The price of the car is $18,000 but the amount you need to borrow is reduced by the amount of your down payment. So, in this case, the principal on your loan will be $16,000, not $18,000.

Installment Loans – are loans where you borrow a fixed amount of money and make monthly payments until the loan is paid off. The monthly payment amount is typically fixed — you pay the same amount every month for the life of the loan. Examples of installment loans are car loans, most student loans, and store loans for large purchases like computers, phones, and furniture.

Mortgages – are technically installment loans but they are usually considered their own category or loan type. [Mortgage interest is amortized, which is special way of calculating interest that is beyond the scope of this guide.]

Revolving Credit – is a type of loan without a fixed principal. Instead, your lender will pre-approve a maximum loan amount. You can borrow as little or as much of that amount as you need — borrowing, paying back, and then borrowing again on a revolving basis up to your maximum. Monthly payments vary depending on much you’ve borrowed. Credit cards are the most common type of revolving credit consumers use.

Credit Limit – is the pre-approved limit placed on revolving credit accounts by lenders.

Overdraft – when you make a purchase (or purchases) with your debit card in excess of how much money you have in your bank account.

Overdraft Protection – is a “service” some banks “offer” on some accounts. Don’t be fooled by the comforting terminology – their protection comes with lots of fine print and extra fees.

Interest – the cost of money. Interest works both ways — you can pay it or you can earn it. If you’re borrowing money, you’re paying interest. If you have money saved (in the right type of account), you’re earning interest.

In respect to interest, two terms you’ll see frequently are:

APR – stands for Annual Percentage Rate (emphasis on the word rate). This is the rate of interest you pay.

APY – stands for Annual Percentage Yield. The yield is the amount of interest you earn.

Two more interest-related terms are:

Simple Interest – interest that is calculated based only on the principal. In very simple terms, your payment is calculated once per period (usually once per month) using a very simple formula:

Principal x Interest Rate = Payment Due

Compound Interest – well, it compounds (re: gets bigger). In other words, you pay interest on the interest. How it works is that unpaid interest charges are folded into the principal making the loan amount grow so the next time interest is calculated your interest rate is multiplied by the new larger principal amount.

How’s that for scary and confusing?!

Oh, but it gets worse. Credit card interest is calculated using compound interest. And, worse still, credit card interest usually compounds daily. [I’ll dig more deeply into compounding credit card interest later.]

In light of this new delightful concept that is Compound Interest, you need to add one more term to your interest-related vocabulary:

DPR – stands for Daily Periodic Rate. This term applies mostly to credit cards but is applicable to any daily compounding interest rate—say from your local loan shark or a payday loan company. The DPR is your APR (see above) divided by 365 (days in a year). The result of that calculation is the daily rate at which your credit card debt compounds. [This is a generalized explanation; some credit cards round to 360 days, etc. If you’re interested in the details of how your credit card calculates your DPR, check the fine print (terms and agreements) of your cardholder agreement.]

Now that you have some basic terms mastered, let’s get into the nitty gritty of Debit vs. Credit: The Good, The Bad, and The Ugly.

next >> Section 1.2: Debit Cards