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What credit is, why you need it, and how to know if you're creditworthy

At a glance:

Credit is an important part of the American economic system; without it, our economy would come to a screeching halt. Credit has been around as long as there has been money. It helps the flow of commerce. However, credit is subject to abuse by both the creditor and borrower. For this reason the federal government and many state governments have passed laws regulating fair credit practices.

When used wisely, credit is your friend; used unwisely, it can become your worst nightmare.

What is credit?

Credit is a loan of money. The loan may be for a short or long term. Sometimes the loan requires a formal application process; other times, it is made by the use of a simple plastic credit card—once the borrower's creditworthiness has been established.

Here is how it works

There are two parties to a credit transaction. The creditor is the party who lends money. A creditor can be an individual or institution such as a bank, credit union, or lending company. The creditor is sometimes just referred to as the lender. The debtor is the party who borrows money (the borrower).

A creditor lends money for financial gain. When the creditor lends money to a debtor, the creditor expects that the principal (original amount of money) will be repaid in a timely manner with a premium called interest. Interest is the amount of money the creditor earns for lending money. Interest is usually expressed as a percentage of the principal amount to be repaid in addition to the principal. Sometimes interest is called the finance charge.

How interest works

Interest may be simple or compound. Simple interest is paid as a percentage of the principal amount borrowed only. For example, 5% simple annual interest paid on principal of $100 is $5.00 per year that the principal remains unpaid. Compound interest is paid as a percentage of the unpaid principal and unpaid interest, so 5% annual interest compounded quarterly would be $5.09. Each quarter, 1.25% of the balance due is added to the unpaid loan balance so that in the first quarter the loan balance goes to $101.25, then in the second quarter to 1.25% x $101.25 + $101.25, and so forth. As you can see, compound interest is more expensive than simple interest.

Most credit transactions in the United States require monthly payments of both principal and interest. These range from monthly mortgage payments to automobile loan payments, to credit card payments, to installment payments, to medical care providers, etc.

There are limits

Credit agreements provide a credit limit up to which the debtor can borrow. In some arrangements, the agreement terminates when the loan is repaid. In others, the debtor can continue to borrow and repay amounts as long as the outstanding balance does not exceed the credit limit—such arrangements are referred to as revolving credit. Credit card agreements are an example of revolving credit.

Why you should get your credit report periodically

If you are denied credit or employment based on information contained within a credit report, you are entitled to a free report of the credit report that was used to make the determination of your denial if you request this report within sixty days of the denial.

Additionally, you can request a free credit report once every 12 months from each of the three credit bureaus at annualcreditreport.com. You should request a report from all three credit bureaus, as they may contain different information about you. Equifax offers a combined report from all three agencies—and consumers can also request a copy of their FICO® score for nominal fees.

Your credit profile matters

Using information from your credit history, creditors use a mathematical credit scoring model that computes the probability of your being a good credit risk. This is a financial profile used to compare you to others of the same profile to determine how much of a credit risk you pose. If your risk profile shows that you are a high risk, you may be denied credit. You may also be denied credit if you have no profile. Some advisors recommend that young adults establish a credit history by making credit card purchases and paying them immediately to generate a favorable credit record.

Credit is an important financial tool that allows consumers to acquire goods and services they need immediately, although they may not have the cash available. It should not be used to make impulse purchases, since the interest and finance charges greatly increase the cost of those purchases. Irresponsible use of credit could lead to financial hardship and may result in bankruptcy.

How lenders rate creditworthiness: The 3 Cs

Lenders must evaluate the risks of lending money to others. In commercial lending, creditors generally follow the same principles to evaluate a borrower's creditworthiness.

The keys to your creditworthiness

A creditor usually looks at three factors known as the "three Cs": capacity, capital, and character.

  • Capacity. The present and future ability to meet your financial obligations. Some of the areas examined would be your work history and the amount of debt that you already owe.

  • Capital. Savings and other assets that could be used as collateral for loans. Even if you are not required to post collateral, many creditors express a preference that you have assets other than income that could be used to repay a loan.

  • Character. This boils down to trustworthiness, promptness in paying your existing bills and other debts, and your credit history.

In days of old, the "three Cs" may have been all that were needed to get the nod on a loan, but in today's information age, much more is required, such as a credit report and credit score.

Southern states have more credit card debt. (David Foster/Cashay)
Southern states have more credit card debt. (David Foster/Cashay)

What is a good credit score? The basics

Your FICO score

The credit report represents a long list of a person's payment history, credit accounts, and other information. The credit report itself is available free, but the credit score is not included. Perhaps more important is one's credit score—called a FICO score—which is named after the company that developed it: Fair Isaac and Company (www.myfico.com).

The score is a three-digit number that falls between 300 and 850. The higher the number, the more confidence lenders have that a person will be able to repay their debt on time. Although other companies provide credit scores, the FICO is the dominant score used in the industry.

How your FICO score is weighted

About 60% of people have scores of 700 or more. At 720, a person is considered a safe risk and typically receives a loan without a problem and at a low interest rate. The FICO score is weighted as follows:

  • 35% payment history. Having a long history of making payments on time and no missed payments on all credit accounts is one of the top things that creditors look for.

  • 30% amount owed. This area measures the amount someone owes relative to all of the credit they have available to them. If a person is very close to the limit on all lines of credit, they can be deemed a potential risk in the ability to repay their debts on time.

  • 15% length of credit history. In general, a credit report containing a list of accounts opened for a long time will help a person's credit score. The score considers one's oldest account and the average age of all accounts.

  • 10% new credit. Opening several new credit accounts in a short period of time can result in a lowered credit score. Multiple credit report inquiries can represent a greater risk, but this does not include any requests made by the individual, an employer, or a lender who does so when sending the individual an unsolicited, "pre-approved" credit offer. In addition, to compensate for rate shopping, the score counts multiple inquiries in any 14-day period as just one inquiry.

  • 10% types of credit in use. A person's mix of credit cards, retail accounts, finance company loans, and mortgage loans is evaluated.

Types of loans

Not only do lenders need to be careful about whom they lend money to, but borrowers must also beware. If you understand the basic types of loans and the laws that regulate credit, you will be a better consumer.

Loans may be secured or unsecured. A secured loan is money loaned that is backed by some collateral pledged by the borrower, such as a car, stocks, or real estate. If the borrower defaults on the loan by failing to make payments, then the lender has a right to liquidate the pledged collateral to satisfy the loan. Unsecured loans are made solely on the good faith of the parties involved, such as with a personal loan. Most loans require regular timed payments.

Installment loans

Installment loans are repaid over a specific time (term) with set monthly payments of interest and principal. Terms vary by the type of loan. For example, an auto loan might be for 60 months while home equity loans can range up to 180 months, and mortgages up to 30 years (and even 40 years in certain cases).

Debt consolidation loans

Some of these loans require collateral, and some require a co-signer. If you use a collateralized debt consolidation loan, you turn your unsecured debt into secured debt, backed by your collateral. These do not reduce your debt, but make payments easier by offering lower interest rates and a longer payment term.

Credit regulations designed to protect consumers

The Fair Credit Reporting Act (FCRA)

Enacted in 1971 and amended in 1997, this act is enforced by the Federal Trade Commission (FTC) and state consumer protection agencies. It is designed to improve the confidentiality and accuracy of credit reports and gives consumers specific rights and protection. Consumers have the right to:

  • view their credit records at credit reporting bureaus.

  • challenge and correct negative aspects of their record if they can prove there is a mistake, and submit statements explaining why they received certain negative credit marks.

  • have inquirers get written permission before their credit reports are released.

  • not be included in direct mail or telemarketing solicitations based on pre-screened lists obtained from credit bureaus.

  • have claims of disputed information investigated and reported back to them within 30 days.

  • have adverse information involving collections or charge-offs removed from their credit record using a fair "date certain" calculation.

The Fair and Accurate Credit Transactions Act of 2003, an amendment to the Fair Credit Reporting Act, allows consumers to get a free credit report once every twelve months from each of the three national consumer credit reporting companies (Experian, Equifax, and TransUnion). These three major credit reporting agencies have set up a Website—annualcreditreport.com—to provide free access to annual credit reports.

Truth-in-Lending Act of 1968 and Regulation Z

This federal regulation, which is enforced by the Federal Reserve System, requires creditors to establish uniform methods for computing the cost of credit, disclosure of credit terms, and procedures for correcting errors on certain credit accounts. It also grants consumers the right to cancel certain credit transactions that involve their principal residence if they decide not to go forward with a loan.

Credit terms

The Truth in Lending law requires lenders to state charges in a clear and uniform manner so that a would-be borrower can compare rates and charges easily. The cost of credit must be expressed in two ways:

  • Finance charge: the total dollar amount that credit will cost the borrower. This includes interest plus any service or carrying charges.

  • Annual percentage rate (APR): the cost of credit as a yearly percentage rate.

Predatory lending

Abusive or "predatory" lenders target people who have cash flow problems, and the loans that these lenders provide have sky-high interest rates and fees. The loans may also be illegal. Particular targets of these lenders are the elderly and people in lower-income brackets who are feeling financial pressure and are struggling to make ends meet. To avoid these lenders, remember a few basic principles:

  • Do you feel pressured to borrow? Avoid pressure tactics.

  • Have you shopped around for the best deal? Use a variety of lending institutions before you commit to anything.

  • Does it seem too good to be true? Be leery of the "Bad or no credit is no problem with us" offers.

  • Do you understand the terms of the loan agreement? If not, ask that any or all parts of it be explained to you.

Get all the advice that you can: family members, tax consultants, lawyers, or other professionals who have knowledge of these matters. Even if they charge a nominal fee, it could save you much grief and money. You can report abusive lenders by calling the FTC toll-free at 1-877-FTC-HELP.

How to use credit responsibly

While credit is very important to the economy, its abuse is harmful. Credit is extended with the faith that borrowers will repay the debt. Goods and services are provided on credit with the expectation that they will be paid for with money in the future. Credit makes commerce more convenient. When credit is abused, everyone loses. Credit abuse increases the cost of credit to everyone.

If you charge it, make sure you can pay it off

One should never use credit to purchase things for which one will not be able to pay in the future. Many impulse purchases are made on credit with little thought given to how the debt will be repaid in the future. If one calculated the true cost of goods bought on credit, one would have second thoughts about making the purchase in the first place. Here is an example: a new television flat-screen HDTV model retails for $5,000.

If purchased on a credit card with a 12% annual percentage rate (APR) compounded daily, and with minimum monthly payments of $166 paid over three years, it winds up costing over $5,980. Is it worth almost $1,000 more to have it now (furthermore, the retail price in 3 years will probably drop)? That is like going into a store that advertised "SALE—ADD 20% TO EVERY PURCHASE."

Make sure you can pay for what you're charging. (Photo: AP Photo/Luis Hidalgo, File)
Make sure you can pay for what you're charging. (Photo: AP Photo/Luis Hidalgo, File)

Credit's purpose is to make it easier to get things

Credit is designed to improve financial transactions. When used responsibly, it does just that. Certainly, there are things we need now for which we do not have all the cash. As long as we understand the cost of convenience (interest and finance charges) as well as having the ability to make the payments until the debt is repaid in the future, then credit may be appropriate if cash is not currently available.

The key is in knowing that the cash will be available. This allows us to purchase homes, automobiles, and other goods and services for which it is too impractical to wait until we save all the funds needed.

When used properly, credit can be a great cash management tool. When abused, it can lead to financial disaster. The cost of credit can be greatly reduced by paying off balances promptly. The longer you take to pay off a credit balance, the more it costs you.

Summary of credit

Credit is a financial transaction wherein one party lends money to another with the expectation that the debtor will repay the full amount of money borrowed to the creditor in a certain amount of time, with additional money for interest or finance charges. Credit is important to the smooth operation of the economy. But credit abuse is harmful, and it will make it harder for you to achieve your financial goals in life.

Although creditors take steps to determine the creditworthiness of a debtor, the process is not perfect. Consumers should view their credit reports to be sure that information on file is complete and accurate. If inaccuracies are found, they should be reported to the credit bureau, which has 30 days to correct the mistake.

Practical ideas you can start with today

  • Obtain your credit report from all three credit bureaus once per year.

  • Dispute any mistakes in your credit report and add any missing positive information.

  • If you don't have a credit card, apply for one — even if only from a gas company or retailer.

  • Use your credit card every month. Make small purchases and pay them off to show you can handle credit responsibly.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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