One in four adults say they plan to pay down debt this year, according to the 2018 Fidelity Investments New Year’s Resolutions Study. As a first step, they may want to acquaint themselves with the financial terms surrounding debt and credit. Failure to do so could diminish their chances of success.
“The danger is that you make bad decisions,” says Mary Jane Corzel, senior vice president of Bryn Mawr Trust’s Retail Credit Center. People who don’t understand various financial terms may inadvertently damage their credit or even end up deeper in debt. Make sure you understand the following 12 terms:
APR. When it comes to debt, no term may be more important than annual percentage rate, or APR. That is the amount of interest and fees charged to a debt each year. It seems straightforward, but some people confuse its meaning. “Many people assume it’s simple interest when, in fact, it’s compounding,” says Lara Langdon, vice president of research and algorithm development at online financial advising firm United Income. In other words, interest is added to the debt on a regular schedule — usually monthly — and as a result, borrowers end up paying interest on previously accrued interest if they carry a balance.
[See: 12 Financial Terms Every Retirement Saver Should Know.]
Variable rate. Interest rates on loans can be fixed or variable. Fixed rates allow borrowers to lock in the current interest rate, while the rates on variable loans change over time. For instance, adjustable rate mortgages may lock in one rate for a certain number of years and then reset to the current market rate at a designated time. “We’re in a rising rate environment,” Corzel says. That means borrowers who consolidate debt into a variable loan could pay higher interest rates in the future.
Introductory rate. Credit cards and some loan products may offer a low introductory rate to encourage customers to consolidate debt or transfer balances. “The introductory rate is what’s going to attract your eyes at first,” says Sean Stein Smith, a business and economics assistant professor at Lehman College. However, you should not make decisions based on the introductory rate alone. Stein Smith encourages a careful reading of the fine print to understand when the introductory period ends and how much interest will be charged in the future.
Origination fee. Lenders may charge an origination fee to set up a loan. It’s a fee you may miss since it’s often rolled into the total amount borrowed. “It’s important to evaluate the effect of those fees,” Langdon says. Higher fees can mean a longer payback period or greater interest charges. The origination fee is included in the calculation of the APR, so you can use this measure to compare costs from lender to lender. Just be sure you are looking at a loan’s APR rather than only the base interest rate.
Annual fee. Most commonly found on credit cards, an annual fee is an amount charged each year to keep a line of credit open. While companies may justify the fee by offering cardholders certain perks, these may not be worth the cost. “In the vast majority of cases, the annual fee is not going to give you extra options not found elsewhere,” Stein Smith says. Borrowers may be able to find fee-free cards that offer similar perks or discover they already get benefits, such as rental car insurance, through their existing insurance policies or financial products.
[Read: How to Manage Your Debt as Interest Rates Rise.]
Minimum payment. Revolving lines of credit, such as credit cards, often require a minimum payment each month. Although minimum payments may seem self-explanatory, finance experts say borrowers may not understand their significance. Paying only this amount makes it difficult to get out of debt. A minimum payment may be only enough to cover interest and not much else. “You may not really be making an impact at all on the principal,” Corzel says. Borrowers hoping to get out of debt as quickly as possible should send in more than the minimum payment each month.
Credit bureau. When it comes to credit, every consumer needs to be familiar with the credit bureaus Equifax, Experian and TransUnion. “There are others, but these are the three major bureaus lenders are using,” says Ash Exantus, director of financial education at BankMobile. The credit bureaus track information provided to them by lenders and create credit reports for each consumer. These reports are often used to make lending decisions. To ensure information is accurate, the government allows people to request one free credit report from each of the three major credit bureaus each year. These can be requested at AnnualCreditReport.com.
Credit score. Information from credit reports is also used to calculate credit scores. Credit scores are available from a number of companies, but FICO and VantageScore are among the most prominent providers. Both use a scoring scale from 300 to 850, with higher numbers corresponding to better credit. Lenders may use scores to determine whether to approve a loan or what interest rate to offer. Although plenty of credit cards, banks and websites offer free credit scores to consumers, be aware the score offered by these sources may not be the same as that used by a particular lender.
Debt utilization ratio. There are many factors that go into a credit score, but the debt utilization ratio may be the one that confuses people the most. “I think this is one of the most important terms people need to know, but they don’t,” Exantus says. The debt utilization ratio refers to how much of a person’s available credit is being used. For instance, a person who has maxed out their available credit has a 100 percent debt utilization ratio. Someone who doesn’t have any debt charged to their credit cards has a zero percent debt utilization ratio. Exantus notes once you exceed a 30 percent ratio, it can begin to negatively affect your credit.
Debt consolidation company. People hoping to get out of debt quickly may look to an outside party for help. Debt consolidation companies tout themselves as one way to save money and time on the repayment process. But not all companies operate the same way, and consumers should be careful to review business practices before agreeing to a firm’s services. “A lot of time, what these debt consolidation companies are doing is that they aren’t paying your bills,” Extanus says. While their name implies their purpose is to consolidate bills into one payment, they may actually be withholding payments from creditors in order to negotiate a debt settlement.
[Read: How to Keep Your Social Security Number Safe.]
Debt settlement. A debt settlement means a lender agrees to take a smaller amount than what it owed on an account. While debt consolidation companies often use this tactic, consumers can negotiate their own settlements. It’s advisable to always get the terms of a settlement in writing and be aware that having a settlement listed on your credit report could negatively impact your credit profile.
Financial literacy. While not a term that relates specifically to debt and credit, financial literacy is something essential to anyone who wants to improve their money situation. Being financially literate means understanding the basics of finances and how to make smart use of money.
In today’s digital age, it’s not hard to find financial information online, but consumers need to be wary of marketing material dressed up as educational content. “Make sure there isn’t a sales pitch interwoven into the information provided,” Stein Smith says. He recommends people use unbiased sources such as the American Institute of CPAs, which runs the websites FeedthePig.org and 360FinancialLiteracy.org.
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12 Terms You Need to Know to Get Out of Debt and Clean Up Your Credit originally appeared on usnews.com
