We're a nation of borrowers. The total UK personal debt stood at a staggering £1,460 billion at the end of March 2010, according to money education charity Credit Action. That equates to an average of £30,258 a person.
But while some credit is bad and can quickly leave you owing far more than you borrowed, credit, when used smartly, can be a useful tool in your financial planning.
Used correctly, a credit card can be particularly useful, Andrew Hagger, spokesperson for Moneynet, explains: "If you can repay your balance in full every month you'll pay no interest.
"Unfortunately many people fall into the trap of only making the minimum monthly repayment each month of around 3% of their balance, which can be very expensive."
For example a £2,000 credit card debt at 12.9% with 3% minimum repayments would take 167 months – nearly 14 years, to clear, stacking up an extra £1,016 in interest.
If repaying the balance each month isn't viable, then look for 0% balance transfer cards. These allow you to switch your balance, usually for a fee of up to 3% of your balance, in exchange for up to 15 months without any further interest charges.
However, watch out for payment hierarchy. "Many card providers use your payments to pay off the balances with the cheapest rate first.
For example, if you transferred £1,000 to your card and then used it for £300 worth of shopping, when you paid £300 on your next statement this would go to repay some of your 0% debt, leaving interest to build up on your purchases," says Hagger.
The good news is that providers will be forced to change their rules by January 2011 so that the most expensive borrowing is repaid first.
For short-term borrowing, an overdraft on your bank account is another option, as long as you've arranged it beforehand.
"Arrange this just in case you get an unexpected repair bill for the car or your pay cheque is delayed," says Hagger. "You'll pay interest charges for the days you're overdrawn but the costs are quite reasonable."
For example, at the average agreed overdraft charge of 14%, being overdrawn by £500 for 15 days would cost £2.87.
"Compare this to unauthorised borrowing on your current account, where being just £50 overdrawn for three days could cost up to £60," Hagger adds.
If you want to borrow for a longer period, perhaps to buy a car, pay for a wedding or to clear some expensive debts, a personal loan is likely to be a cheaper option.
Personal loans allow you to borrow for a longer period, generally between one and seven years, with the monthly repayments fixed for the term of the loan.
There are catches with personal loans though. "Be careful if your lender suggests you take out payment protection insurance, which covers your loan payments in the event of accident, sickness or unemployment," warns Hagger.
"It can be a useful insurance to have but is often more expensive than if you were to go to an independent provider."
Three credit traps to avoid
These are an expensive way of borrowing, despite the attractive incentives. Some cards charge close to 30% in interest and even those with lower rates are best avoided unless you can take advantage of the deal and repay the balance straightaway.
Enabling you to borrow money for the short term, while the amount you pay may seem relatively low, the APRs can be extortionate. For example, borrowing £100 for five days could cost you £25 – an interest rate of 1,737%.
Hire purchase agreements
Also known as a conditional sale agreements, this is a common way to purchase big ticket items such as cars or furniture. The rates aren't necessarily bad but the terms are more restrictive. Unlike credit, you don't legally own the goods until you've paid back all the money. This means you can't sell the item and, if you fall behind on payments, the retailer can ask for it back.
Short-term cash loans designed to be borrowed mid-way through the month to tide the borrower over until they next get paid, whereupon the loan is settled. Generally used by people with bad credit ratings and/or no access to short-term credit such as an overdraft or credit card. Like logbook loans, this type of borrowing is hugely expensive: the average APR on payday loans is well over 1,000% and in some instances can be considerably more.
An overdraft is an agreement with your bank that authorises you to withdraw more funds from your account than you have deposited in it. Many banks charge for this privilege either as a fixed fee or charge interest on the money overdrawn at a special high rate. Some banks charge a fee and interest. And other banks offer a free overdraft but impose very high charges for exceeding the agreed limit of your overdraft.
Used by the holder to buy goods and services, credit cards also have a monthly or annual spending limit, which may be raised or lowered depending on the creditworthiness of the cardholder. But unlike charge cards, borrowers aren’t forced to pay the balance off in full every month and, as long as they make a stated minimum payment, can carry a balance from one month to the next, generating compound interest. As the issuing company is effectively giving you a short-term loan, most credit cards have variable and relatively high interest rates. Allowing the interest to compound for too long may result in dire financial straits.
Moving money from one account to another, whether switching bank accounts or more likely transferring the outstanding balance on your credit card to another card that charges a lower – or 0% – rate of interest. Some card providers may charge a transfer fee that can be a percentage of the balance transferred.
An account opened with a clearing bank (few building societies offer current accounts) that provides the ability to draw cash (usually via a debit card) or cheques from the account. Some pay fairly minimal rates of interest if the account is in credit. Most current accounts insist your monthly income (salary or pension) is paid directly in each month and they offer a number of optional services – such as overdrafts and charge cards – which are negotiable but will incur fees.