FS-2025-0755 | October 2025
Consumer Credit: Balancing Access and Risks to Achieve Financial Stability
By Troy Anthony Anderson, Ed.D. and Jesse Ketterman, Ph.D.
In today’s world, securing credit and using it wisely is a cornerstone of effective financial planning. It empowers individuals to control their cash flow, to afford major purchases like homes or cars, and to shape a secure financial future through strategic borrowing and responsible repayment. In financial management, credit means buying now and paying later, typically with added interest charges; it is the ability to access goods and services upfront. Individuals can obtain credit for various reasons, yet the majority of it is categorized into three main types: installment credit with set payments, revolving credit such as credit cards, and open credit accounts offering adaptable borrowing. Despite the additional finance charges associated with credit, it allows for quick access to goods and an extended repayment period. Hamid and Loke (2021) highlighted the necessity for credit users, individuals, and families, to consistently fulfill their payment obligations according to the stipulated deadlines. For this reason, budgeting is critical in determining fixed, variable, and periodic expenditures from a person’s earnings to ensure a pragmatic approach to money management.
To avoid future financial hardship, those intending to use credit should assess their needs and create a plan detailing how the credit will be utilized and repaid responsibly. Buying the latest brand of clothing with credit might not be the best use of credit. Amidst the intricate web of consumer lending, where financial debts seem overwhelming, individuals and families pursue credit for a myriad of needs and wants. Consequently, families might purchase new tools or equipment to improve their small businesses, while others might decide to pursue higher education, taking evening classes or online courses. As a result, their enhanced skills and knowledge lead to a higher household income. This is an example of employing credit for a good reason and with a commendable goal.
An individual’s income and savings might not always provide enough cash flow to cover every expense. Therefore, access to credit, secured by expected income, is a cornerstone of consumer behavior, influencing spending habits and overall economic well-being (Herkenhoff et al., 2021). Credit, therefore, can be a tool for building wealth when used carefully, or it can be misused, leading to financial problems.
Types of Consumer Credit
Consumer credit, often referred to as personal credit, provides individuals with the means to finance essential purchases by allowing them to spread payments over time. This section introduces a table that highlights the various types of consumer credit, offering descriptions and discussing the pros and cons associated with each option. By understanding these types of credit, consumers can make informed decisions about obtaining loans and managing repayments, facilitating the acquisition of goods and assets through deferred payment.
| Types of Consumer Credit | Description | Pros & Cons |
|---|---|---|
| Cash loans | Such products are offered by financial institutions, such as banks, finance companies, and credit unions. Repayment terms can differ for each loan; factors like the length of the repayment period and the associated interest rates will vary. In some cases, borrowers repay the principal and accumulated interest in one lump sum on the agreed-upon date; other times, they make payments in installments over a set period. In other instances, interest accrues only upon loan maturity, at which point the full amount is repaid. | Pros:
Cons:
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| Hire purchase agreements | This feature restricts transactions to the purchase of one item at a time. A formal payment arrangement is structured for the buyer, extending over an 18- to 24-month period. The acquisition of high-value assets, including electronics, furniture, and home appliances, is facilitated by hire purchase (installment credit) structures that enable payment over time. Under a hire purchase agreement, title to the goods remains with the vendor until full payment is received. | Pros:
Cons:
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| Charge accounts | Customers receive credit through charge cards (also known as charge accounts), which permit deferred payments, typically due in 30 days. Full payment is required each month for charge accounts. Unlike credit cards, there is no preset spending limit on charge accounts. This cashless system is convenient for shoppers; there is no need to carry cash, making shopping quicker and easier. | Pros:
Cons:
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| Lay-away plans | A layaway plan allows customers to buy items by making a deposit and paying the remaining balance in installments. The retailer holds the item until fully paid. For example, if you find a TV but cannot pay in full, the store can hold it while you pay over time. | Pros:
Cons:
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| Credit cards | Credit cards provide consumers with a revolving line of credit, acting as a type of personal loan that enables them to borrow money within a specified limit. In contrast to traditional loans, credit cards feature minimum monthly payments, but carrying a balance incurs accumulating interest charges that grow with each passing month when a credit card balance is not paid in full. The flexibility of credit cards for short-term borrowing and credit building is offset by the risk of high-interest debt if spending is not carefully controlled. | Pros:
Cons:
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| Home equity loans | Home equity loans are personal loans secured by the equity in a homeowner’s house, enabling them to borrow a sum based on their home’s value. The home’s current market value, minus any outstanding mortgage balance, determines the loan amount. These loans typically offer fixed interest rates and are repaid over a set term, often between 5 to 30 years. Home equity loans can be used for various purposes, such as home improvements, debt consolidation, or major expenses. | Pros:
Cons:
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| Auto loans | An auto loan is a type of personal loan specifically used to purchase a vehicle. Car financing allows borrowers to pay for a vehicle gradually, usually necessitating an initial down payment and consistent monthly installments for a specified duration. Creditworthiness and loan terms are key factors that influence the interest rate a person will receive. The monthly payments with longer loan terms mean that the cumulative interest charges often far exceed those of shorter-term loans. For example, the car being bought secures the auto loan, which sets the loan apart from a standard personal loan. As a result, the lender can seize the car if one payment is missed, but most lenders will wait for up to 90 days. | Pros:
Cons:
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| Payday loans | A payday loan is a small, high-cost loan (typically under $500) repaid on the consumer’s next payday. State laws around payday loans vary but the process is usually quick. The process involves the payday lender verifying the consumer’s income and checking account, followed by the consumer receiving immediate cash at the storefront location. | Pros:
Cons:
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| Education loans | The purpose of education loans is to finance the cost of a degree, encompassing tuition, required books and other learning materials, and the student’s cost of living. Many lenders allow students to defer loan payments during college and for six months afterward. Federal student loans for higher education include direct subsidized and unsubsidized loans (based on financial need and creditworthiness, respectively), PLUS loans (for parents or graduate students), and direct consolidation loans for simplifying repayment. | Pros:
Cons:
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| Mortgages | A mortgage involves borrowing money secured by the purchased property; if an individual defaults, the lender may foreclose and take ownership of the person’s home. A key difference between mortgages and other loans is their significantly longer repayment terms, and the collateral involved. When a mortgage goes into default, the lender will typically foreclose on the property and sell it at auction to recover their investment. | Pros:
Cons:
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Advantages & Disadvantages of Credit
The advantages of credit are numerous for individuals, from building one’s credit history to facilitating large purchases. Therefore, the function of credit is crucial for a country’s economic health and stability. However, relying on credit for everyday purchases can create a cycle of debt, with accruing interest and potential late payment fees, which can pose a significant financial risk. The table that follows presents a comparison of several strengths and limitations of credit.
| Strengths | Limitations |
|---|---|
|
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Determining Access to Credit
When a person applies for credit, the lender is likely to ask for some information. That may include, but is not limited to, pay stubs, W-2 forms, tax returns, bank statements, proof of identity, and/or social security number. The consumer will also need to fill out a loan application. This may include their current debt balances and/or payment amounts. The lender will also look at one or more of the applicant’s credit reports and their credit score(s). With this information, the lender will decide if and to what amount of credit it will extend to the applicant.
To determine how much credit someone may have access to is going to depend on their payment history, total debt, usage of available credit, credit history, and credit mix. In fact, credit scores are based on these factors. Each one impacts a consumer’s credit score which is an indicator of their likelihood to repay a loan.
The largest two factors are the consumer’s payment history and the amount of money they owe. In essence, delinquent consumers with substantial debt are less likely to qualify for a loan. A consumer might get a loan, but the interest rates could be higher compared to someone with a good payment history and minimal debt.
Another item considered is the consumer’s debt-to-income ratio (DTI). The consumer can calculate it by dividing the sum of their monthly debt payments by their gross monthly income (their income before any deductions such as taxes). This will give the consumer a percentage. For example, if John’s income is $1,000 and his monthly debt payment is $300, his debt-to-income ratio is 30% (300/1000). Typically, if he owns a home, that ratio should be kept below 36%. However, if he does not own a home, that number should be less than 20%. The Consumer Financial Protection Bureau has a worksheet and video that can assist consumers in calculating their debt-to-income ratio.
Could Securing Additional Credit Jeopardize my Financial Stability?
Consider the following scenario: a prospective buyer lacks the capital to purchase a vehicle. Is using credit for the purchase a smart idea?
The prospective buyer must determine their financial capacity to take on the debt of vehicle payments immediately or defer the purchase until sufficient funds are accumulated. In this instance, the 20 percent rule provides a metric for assessing an individual’s borrowing capacity. To maintain financial stability, the buyer’s combined debts (excluding their home loan) must remain below 20 percent of their net monthly income. This results in manageable levels of debt. For instance, based on the 20 percent rule, a $4800 monthly income allows for a $960 monthly credit payment ($4800 x 0.20 = $960).
When combined loan and credit card payments surpass $960, individuals may experience financial difficulty and subsequent payment delinquency. Through the calculations and comparisons listed below in Worksheet 1, one can get a clearer picture of their credit capacity, assessing their financial health and income.
Worksheet 1: Credit Capacity Assessment
- Monthly Net Income $__________
- Multiply by 20% __________ x0.20
- Maximum acceptable debt per month. $ __________
- Your present multiple debt obligations. $ __________
Carefully compare lines 3 and 4 to identify any differences. If the prospective buyer’s current monthly expenses exceed their maximum debt limit, they will be unable to afford the car. If adding the car payment to their current monthly debt does not exceed the debt limit, they can afford it. This car loan demonstrates how borrowing can be used intelligently, based on careful planning.
What happens if I fall behind on a loan?
Anyone struggling financially should promptly inform their lender, explaining the reasons for their payment difficulties. A revised payment plan can often be arranged to fit the individual’s situation, with the cooperation of most lenders. It is also important to speak with the lender when they call, as various issues could arise. Ignoring a cold call from a lender can lead to several complications. First, not engaging in communication might result in the lender assuming that you are unwilling to address your debt, which could escalate the situation. This lack of dialogue might lead to more aggressive collection efforts, including legal action or the involvement of collection agencies, both of which can negatively impact your credit score and financial standing.
Furthermore, failing to communicate your financial struggles and the reasons behind missed payments can prevent you from negotiating a more manageable repayment plan. Many lenders are willing to work with borrowers who are proactive and honest about their financial difficulties, offering options such as deferred payments or adjusted interest rates. By ignoring calls, you may miss the opportunity to alleviate some financial pressure through these arrangements.
When you receive a demand for debt payment by letter or phone, it’s crucial to establish clear boundaries. A common first step is to send a letter to the creditor or collection agency requesting written validation of the amount owed. Be sure to keep a copy of the letter for your records. Ensure that the letter includes the name, address, and relevant account number. If possible, send the letter via certified mail, which requires a recipient’s signature as proof of delivery. The certified letter signature card is returned to you; keep this for your records as well.
Consumers can ask creditors or collection agencies for proof of debt, like a copy of the signed contract or agreement in the case of a credit card; however, these entities are not obligated to provide it. For example, to verify a debt, a single monthly credit card statement that has been sent to the consumer can serve as evidence. The methods used for debt collection can vary significantly, encompassing approaches from polite reminders to more assertive measures, contingent upon the creditor’s policies and the debtor’s behavior. The specifics of debt handling will depend on each lender’s unique policies and their accounting practices, but the process often begins 60-90 days after the first missed payment. Lenders might first pursue internal collection efforts, sometimes culminating in a debt write-off and subsequent sale to an outside collection agency.
Although debt validation requests are a legitimate way to challenge debt, their effectiveness is limited, and many consumers find them unhelpful in resolving the actual debt issue. In most cases, creditors and collection agencies can readily supply the needed documentation, such as contracts or payment records, to verify the legitimacy of the debt. Even without proof of the debt, creditors or collection agencies may still pursue other avenues, such as lawsuits, to attempt collection, leaving the debtor vulnerable to legal action. Even if a debt collector breaks this law, they may continue their collection efforts by suing the consumer for the debt.
The lender may file a suit in small claims court, magistrate court, or state court to obtain a court order for payment; this process often involves paperwork, hearings, and potential legal fees. The court’s decision, called a “judgment,” may have wide-ranging impacts. A ruling in favor of the lenders could mean a substantial 25% reduction in a consumer’s take-home pay due to wage garnishment to repay the debt plus any other expenses documented by the lender, such as court costs and legal fees. In addition, lenders can legally seize funds from a consumer’s checking or savings account to fulfill a court order. As a result, consumers in financial distress need to address the situation as quickly as possible. A good place to start is with the resources from the Consumer Financial Protection Bureau (CFPB) to assist with understanding debt collection.
The Importance of Credit in Financial Planning
Understanding the intricacies of credit and its influence on financial health is crucial. It not only affects the ability to make significant purchases but also impacts one’s financial reputation and future borrowing capabilities. Proper management of credit can lead to favorable interest rates and loan terms, ultimately saving money and enhancing financial stability. Conversely, poor credit management can lead to increased costs, limited financial options, and potential financial distress.
The eligibility for consumer credit is contingent upon a credit score. A high credit score unlocks access to loans with the best interest rates, easing the financial strain and saving the consumer money in the long run. It also positively impacts the ability to purchase a home, the opportunity for employment involving financial responsibility, and the prospect of obtaining insurance with lower premiums and higher deductibles. Having access to credit provides a safety net in emergencies, allowing for unexpected expenses to be managed without derailing financial stability. It can also be an investment tool, enabling individuals to access otherwise unreachable opportunities and potentially grow their wealth.
To navigate consumer credit effectively, individuals should begin by learning how credit scores impact their financial future, comparing interest rates from different lenders, and comprehending the often-complex details within credit agreements. Individuals who regularly review their credit reports can pinpoint inaccuracies and discover opportunities to boost their credit score, by disputing errors or paying down debt. Careful budgeting and paying bills on time are essential for a good credit score. This also prevents late fees that can result in negative marks on the individual’s report. Additionally, consumers are wise to compare credit products, understand their fees, and to use credit responsibly to avoid accumulating unmanageable debt. By staying informed and proactive, individuals can leverage credit to their advantage, ensuring a solid foundation for their financial plans.
In this complex world, credit opens the door for individuals to have access to money for goods and services that otherwise may not be available with cash-only payments. Using credit is a tool to achieve a person’s financial goals. When misused, it can become a burden on their financial plan and can increase stress in their life. One should consider credit only after evaluating their financial situation. Managing credit should begin with establishing financial goals and calculating personal net worth. Keeping a close eye on expenditures, allocating funds strategically, and formulating a spending plan are essential tasks for financial management. With these actions in mind, an individual can make informed decisions about obtaining and using credit, understanding its implications for their financial future.
References
Hamid, F. S., & Loke, Y. J. (2021). Financial literacy, money management skill and credit card repayments. International Journal of Consumer Studies, 45(2), 235-247.
Herkenhoff, K., Phillips, G. M., & Cohen-Cole, E. (2021). The impact of consumer credit access on self-employment and entrepreneurship. Journal of financial economics, 141(1), 345-371.
TROY ANTHONY ANDERSON
tanders4@umd.edu
JESSE KETTERMAN
jketterman@umd.edu
This publication, Consumer Credit: Balancing Access and Risks to Achieve Financial Stability (FS-2025-0755), is a part of a collection produced by the University of Maryland Extension within the College of Agriculture and Natural Resources.
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Anderson, T.A., & Ketterman, J. (2025). Consumer Credit: Balancing Access and Risks to Achieve Financial Stability (FS-2025-0755). University of Maryland Extension. go.umd.edu/FS-2025-0755