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CREDIT PART ONE: CREDIT AS A BORROWER

 

Credit is important to understand because it directly impacts every aspect of our financial lives. While credit can provide access to something that could provide tremendous future value, it could also derail our financial stability if it’s taken or used in excess.  This blog post is part of a three part series covering the components of credit as a borrower and a lender.

Credit is an agreement whereby a borrower receives something of value from a lender now and promises to repay it at a certain date in the future. Since the borrower is giving up something of value today, borrowers typically pay interest to the lender to pay them for this benefit. In this blog post, we’re going to discuss important terms to understand in credit agreements and how to establish and build credit. As a borrower, credit is commonly referred to as a loan.

We act as borrowers of credit when we have credit cards, mortgages, home equity lines of credit, car loans, student loans and business loans. The terms of each of these types of agreements are unique. Any time you apply for credit, you should understand the terms of the credit agreement. The most important of these are the term, interest rate, payments, penalties and default provisions.

THE DETAILS OF A CREDIT AGREEMENT

Term is the length of time that you have access to credit. Credit cards require that you pay your statement balance off each month in order to avoid an interest rate. Car loans are typically 3-5 years, while mortgages can range from 5-30 years, or longer if refinanced.

Interest rate is the annual rate you are required to pay. But interest rate language can be much more complicated than a single number. The interest rate can be fixed or floating / variable. A fixed interest rate means that the interest rate will not change throughout the term of the agreement. A floating or variable interest rate is typically based on a benchmark rate, such as LIBOR, Prime or Federal Funds Rate. If you have a floating rate of Prime + 3.75% and Prime today is 5.25%, your interest rate will be 9%. Assuming Prime goes up to 6.25%, your interest rate will go up to 10%.  30 year mortgages, federal student loans and auto loans are typically fixed, while credit cards and shorter term mortgages (5 or 7 year ARMs) are typically floating or variable. Credit cards may offer introductory rates at a low fixed interest rate, but after a certain term charge a high variable interest rate.

Payment is the amount that you are required to pay on a regular basis (monthly / quarterly / semi-annual / annual) basis in order to avoid penalties. Certain credit requires that you only pay interest during the term of a loan, which means that the entire balance of the loan would be due at maturity (or the end of the term). This is less common in traditional credit. Most credit requires that you pay more than the interest due, which means that you are paying both interest and principal. Principal is the amount of money you initially borrow.

 
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Penalties can be assessed if you are late or miss a payment, but some credit agreements actually have provisions which penalize you for paying too quickly. Penalties can vary - there can be a fixed fee that is charged if you are late or miss a payment, or it could cause the interest rate on your loan to increase altogether, nullifying the original agreed rate. While penalties for late payments are very normal, there are predatory lenders out there that will throw lots of confusing arrangements in the agreement that could change the terms if you don’t precisely adhere.  

Default provisions are the terms which dictate the worst case scenario - if you can’t make payments on your loan over a certain period of time. The time to default ranges depending on the type of credit, but after 90 days of no payment, it is typical for a loan to be considered in default. The severity of actions against the borrower will depend on the terms of the agreement and the amount of money in question. In all cases, the credit agencies will be notified and this will negatively impact your credit score. In the case of a home mortgage or auto loan, the bank could actually take control of your home or car.

CAN ANYONE ACCESS CREDIT?

In theory, yes. Anyone over the age of 18 (or even under the age of 18 with a sign off from an adult) can access credit. But not all credit issued is created equal. Your ability to access credit, and more importantly access good credit, is dependent upon your Credit Score.

Your FICO score (it’s called FICO because it was created by the Fair Isaac Corporation) otherwise known as your credit score, can range from 300-850. 90% of the top lenders use your FICO score to make all consumer credit decisions (source).

A FICO score uses five factors:

  • 35%  is your payment history

  • 30% is your total debt

  • 15% is the length of credit history

  • 10% is the new credit you’ve applied for

  • 10% are the types of credit you use

The most important factor is your payment history, which means how often you pay your credit on time. This is where the ‘payment’ term comes in - any time you miss the stated required payment, the lender can report this to the credit agencies. If the percent you pay on time is anything less than 100%, this will negatively impact your credit score. For longer term loans, like auto loans and mortgages, this payment will be explicit in your agreement. For credit cards, your credit card company will advise on a monthly basis the required minimum payment.  

Next is the total debt. This aspect of your credit score actually considers two details - the amount of credit available to you and the amount of credit you are actively using (referred to as Credit Utilization). Available credit means that banks or credit card agencies have issued you the ability to use credit. The more credit you have available to you, the better your credit score will be. The second aspect is how much credit you are utilizing. This is particularly important with credit cards because the credit agencies do not want to see that you are maxing out your credit cards. Actually, they want you to use less than 30% of your total available credit. So if you have 5 credit cards total, each with a credit limit of $10,000, your total credit outstanding would be $50,000. Your credit score would be negatively impacted if the amount of money owed to your credit cards exceeded $15,000 or 30% of $50,000.

The last three factors - length of credit history, new credit, and types of credit collectively make up the remaining 35% of your credit score. The longer your credit history, the better. Establishing new credit is good, but if you open too many lines of credit in a short period of time it may negatively impact your score. Lastly, having more types of credit builds diversification in your credit profile and positively impacts your score.

So what should your score be?

  • A FICO score of 800 to 850 is considered excellent - people with excellent credit scores have access to the lowest interest rates and best loan terms. In other words, a higher credit score will save you money.

  • A score of 740 to 799 is very good - if your score is very good you will likely be approved for loans but might pay a slightly higher interest rate.

  • A score of 670 to 739 is considered good - to lenders, you are still considered an ‘acceptable’ borrower, but your interest rates will be higher.

  • A score of 580 - 669 is considered fair - in this range you will definitely pay higher rates and could even be declined for loans and credit. According to myfico.com, you could also be declined for credit!

Monitoring your credit score is an essential part of financial wellness, because individuals with higher credit scores typically have access to the best terms within a credit agreement, specifically the lowest interest rates. Most of us don’t think about this much in our younger years, but your credit score has implications in pretty much every part of your life. It takes about 2 years to establish credit and building credit early is a good thing, so long as it is cared for responsibly.

Some good resources for monitoring your credit score include:

  • We recommend our clients monitor their credit score monthly using either their bank, credit card company, or creditkarma.com. Many banks and credit card companies have this as a perk of being a customer because they know how important it is for individuals to keep track of this score. If your bank or credit card company don’t offer this service, creditkarma.com is a great independent resource that provides you with monthly updates and notifies you of any changes to your credit score.

  • If you are surprised by the results of your credit score, it may be advisable to visit AnnualCreditReport.com to run a credit report. If you have recently applied for credit or had a credit report run, we would recommend requesting your credit report from whoever recently did this as your score may be penalized for too many credit inquiries within a short period of time.

  • Lastly, if there is a particular issue with your credit score according to a specific agency, you can contact the agency directly. The three credit agencies in the US are Experian, Transunion and Equifax. If you know you do not intend to apply for credit anytime in the near future, you are also able to request the credit agencies put a block on your credit, which would help mitigate identity fraud against your credit.