Credit Defined

Credit is the opportunity to get something now by promising to pay for it later. If you use a credit card, have a car loan, or a mortgage you are using credit. Credit is a big part of our lives. It’s one of the main driving forces in our economy. Government, private companies, and consumers all rely on credit to conduct our business.

Credit when used correctly is a great tool to conduct business. If you use credit cards, they are great convenient.  You don’t have to walk around with much cash to conduct business. Without credit, the majority of people couldn’t purchase a home.  Imagine having to pay for a home upfront with no credit. The housing market would be non-existent.

Although credit is great when used correctly, it has its many disadvantages when used incorrectly.  Many individuals don’t use credit for their advantage; they use it to their demise. Many individuals abuse the power of having credit by maxing out their credit cards, opening up too many accounts, missing or skipping payments, making late payments, and defaulting on their loans.

This results in ruining their options for borrowing money, ruining their credit history, and may even ruin unrelated opportunities such as losing a job opportunity or ruining their marriage. Unfortunately, in today’s world, there are unscrupulous individuals who will steal your credit, via identity theft, and ruin your credit.

Poor credit can be fixed.  You can repair your credit yourself.  It’s not rocket science.  There are no tricks to it.  It’s a matter of educating yourself first, creating a plan, and then implementing it. You may have to develop good spending habits, live on a reasonable budget, and develop safe borrowing practices. With time and hard work, your credit will improve so you may enjoy the advantages of having good credit.

Credit comes from the Latin word “credo”, which means, “I believe.”  The underlying beliefs of credit are:

The concept of credit is quite simple.  It basically means that you receive something now in return for you to promise to pay for it later.   It allows you to spend money now, that you plan on earning later. If you have the money, it allows you to conveniently spend money without running to the bank or walking around with cash.

The concept is based on trust.  But how do lenders trust consumers? They look at their historical behavior, which is a great indication of their future behavior. This is why credit reports and credit scores were created to determine your:

• Character – Do you do what you promise, are you reliable, and are you honest?
• Capacity – How debt can you handle with your income and other debt?
• Collateral – What assets do you have to repay your debt if your income is lost?

Creditors offer 2 major types of credit which include:

Interest rates for secured credit are normally lower than unsecured and the length of time to pay back the loan is normally longer than an unsecured loan. An example of a secured loan is a car loan and a home mortgage.  If you fail to repay the car loan or house mortgage, the lender has the right to seize (repossess) your car or your home (foreclosure).

Unsecured Credit is riskier for lenders because there is no asset used as collateral.  The interest rates are higher and the term shorter when compared to secured credit.  The credit is backed by a promise and not by an asset (collateral), causing more risk for the lender.  Credit cards are unsecured credit.

Your Credit Report

• Amount and type of debt – 30%.  The goal here is to have a low balance owed compared to the amount of credit you have available.  That said, having credit cards with small or no balances improves your credit score.
• The length of time you’ve been using credit – 15%.  Accounts that you’ve had at least 2 years will increase your score.
• The variety of accounts – 10%.  Riskier types of credit, such as revolving credit or finance company loans lower your score more so than student loans or mortgage loans.
• The number and types of accounts recently opened (in the last 6 months) – 10%.  In this case, creditors are concerned that if you apply for many accounts at once, you may not be able to pay them.

Your Credit Risk

When lenders determine your rates, or if they are going to lend you money, they first want to know what kind of credit risk you are at.

You are considered a normal credit risk if:

• You have 11 credit accounts reporting to a credit bureau.
• You have never been more than 30 days late on a payment.
• Carry credit card balances of less than $1000.
• Have access to about $12,000 on all credit cards combined.

You are a “higher than normal” credit risk if:

• You have a credit history shorter than two years.
• Have credit card balances of more than $10,000.
• You’ve had an account closed due to default.
• You have had an account that was at least 90 days overdue.

If you don’t fall into either of the above categories, you may fall into a non-traditional category and receive a FICO expansion score. This type of score benefits those in special situations who also need to use credit.

Examples are younger people with little or no credit, those just arriving in the United States, people who use cash often and rarely use credit, and those who previously had joint credit with a spouse and are newly single.

Consequences of Bad Credit