Most people don’t know much about credit, and that can cost you.
Not understanding how your credit score is calculated can lead to financial trouble. For example, did you know that having a high balance on one card will hurt your score even if all of your other cards have zero balances?
Without knowing this it’s hard to avoid these kinds of mistakes.
Let’s dive in.
1.1. The 5C’s Creditors Use to Evaluate You
Each of the five factors begins with the letter C. And of course, ‘Credit’ is one of them. decrease
No matter if you’re looking for a small line of credit on a bank credit card or a million-dollar mortgage to buy a home, creditors want to know how likely you are to repay them.
So, they are looking for ways to understand your financial situation as quickly and accurately as possible. Using credit scores is one way they streamline the process.
So, creditors can make decisions in minutes instead of weeks in some cases. If a creditor believes that you are likely to always pay your loan or credit card bill on time, you’ll get the best, most competitive rates in terms of them.
Depending on how much you borrow, getting low-interest rates can save hundreds or even hundreds of thousands of dollars.
But if a creditor questions your willingness or even ability to pay them back, you’ll either get charged relatively high-interest rates, or you’ll get turned down for credit altogether.
Most of the information creditors want to know about you comes from your credit reports and credit scores. But not all of it. Different creditors evaluate you differently. Plus, the type of financial product that you are applying for also determines the approval process.
For instance, getting an unsecured personal loan, that’s where you just sign a note and promise to repay it. That’s much more straightforward than getting a high-dollar mortgage that’s secured by the property you want to purchase.
To evaluate your overall credit situation, most creditors consider five different factors: the 5C’s of Credit. We will review each of them:
- Capital
- Capacity
- Collateral
- Conditions
- Credit History
So, let’s take about the first one, Capital
What is Capital?
Capital is the same as your assets.
Creditors want to know that you have assets that you could sell or that they could take if you get into trouble and cannot repay your debt.
Your credit reports do not include what asset you own, but they show the debt you owe, such as a mortgage or an auto loan. The more assets you own free and clear, the more a creditor may overlook any bad marks in your credit files.
The second factor that creditors consider is your capacity.
What is Capacity?
This is your financial ability to repay a debt.
They want to know how long you’ve worked in your job or profession and how much you earn to understand how stable your income is. To know how much debt you can afford.
Many lenders use standard calculations such as your Debt-To-Income ratio or (DTI) ratio, which is how much you owe compared to how much you earn.
Some lenders, especially home lenders, have strict percentages. Some may approve a mortgage if your total debt is less than 36% – 40% of your gross income.
Having a high Debt-To-Income ratio means you already have a line of debt and could be having trouble loading a new mortgage on top of it.
So, the lower your ratio, the less risky you appear.
The third C that creditors use to evaluate you is Collateral.
What is Collateral?
This applies to secured loans, which require you to offer an asset that the lender could take if you don’t repay them. Home mortgages and car loans are two types of loans that require collateral.
That’s why you have to have an appraisal on a home before buying it. The lender must verify that it’s worth more than they lend you.
The fourth C is Conditions
What are Conditions?
These are outside circumstances such as the economy and job market that could influence your ability to repay a loan.
And the last C is your Credit History.
What is Credit History?
Lenders review one or more of your credit reports and scores to understand your past and current situation.
They look at factors such as how many credit accounts you have, how much debt you owe, your payment history, and any other tell-tell information such as accounts in collection, leans, and bankruptcies.
Suppose you have a large amount of available credit. In that case, you could be turned down for additional credit, or if you have high balances relative to your available credit, you could be turned down because maxed-out accounts can be a sign of financial trouble.
Creditors want to see how long you’ve had credit accounts and whether you’ve been late in paying any of them as agreed. All this information is what creditors can easily find in your credit reports.
And by the way, if you have no credit history yet, which is known as having a thin credit file, that’s the same as having bad credit.
You must have credit transactions in your history to be possible even to have a credit score. The bottom line is that the lower your perceived risk to a lender, the more likely you will get credit.
But the riskier you seem, the more a lender has to hedge their bet by giving you less favorable terms such as a high-interest rate.
You can say that your credit history is just one component in getting approved for a loan or a credit card, but it’s an important one. If you have great credit, it can offset other factors such as capacity or income and vice versa.
Plus, your credit affects other areas of your financial life. Even if you never plan to borrow money.
In the upcoming chapters, we will cover how the credit system works and how building and maintaining great credit is important for your financial future.
1.2. Overview Of The Credit System
Many people have no idea how the credit system works, and they may not care until they want a credit card, go to buy a car, a home, or take out a loan for any major purchase and get denied.
Unfortunately, typical students are never taught about credit in high school or college. So, it’s no wonder that many people struggle to improve their credit.
You’re at a serious disadvantage if you don’t understand all the components that factor into your scores, credit rights, and various ways to build credit.
Here is what you need to know.
Information about you gets reported to one or more credit bureaus that maintain the debt in your file, known as your credit report. The companies which want to access your credit pay the bureaus for your information. So, credit bureaus don’t make lending decisions; they simply maintain your data.
But, credit reports can be huge. So, companies want a quick way to evaluate you. That’s why credit scores were designed. They are a snapshot of your credit situation.
Credit scores are calculated from the information in your credit reports. And I keep saying credit scores instead of the score because you don’t have one credit score. There are hundreds of different credit score models in use.
Some are propriety systems that lenders create just for themselves, and others are well-known, such as the FICO, which stands for the Fair Isaac Company that created it.
No matter which type or brand a credit score a company or individual uses to evaluate you, scores are simple snapshots of your credit information. As new information is added to your credit reports and old information is deleted, your scores constantly change.
The higher your score, the more trustworthy and responsible you appear.
One of the oldest and most popular credit scores is the FICO. But even with FICO, they offer dozens of different scores. There are newer versions for specific products such as mortgages, credit cards, and auto insurance.
FICO also markets different scores that are custom-made for each of the nationwide credit bureaus.
They tweak the underlying algorithms for different scores and roll them out periodically. The FICO score ranges from 300-850. More than half of the US population has a FICO score of 700 or higher.
Many lenders use a FICO score of 740 as the cut-off for having excellent credit and giving you their best rates and terms.
TransUnion’s TransRisk Score ranges from 300-850. And Equifax’s score ranges from 280-850. Experian’s has a score from 360-840, and another ranges from 330-830. There’s a score that the credit bureaus created together called VantageScore that ranges from 501-990.
So, you see that there are similarities, but no two credit scores are the same. Each score and model evaluate you differently and give you different grades.
So, I don’t want you to worry about keeping every possible credit score because it would be impossible, and it doesn’t matter.
Instead of getting caught up in the nuances of different scoring models, focus on the big picture. Concentrate on what’s in your control and improve your financial behavior, so more positive information gets added to your credit reports, and you’ll be in good shape.
And that’s what we’ll cover in the next section of the guide.
Another important concept to understand about the credit system is that every person has credit reports and sores.
In the United States, your credit data is compiled and tracked by your Social Security number. That means any resident who qualifies for a Social Security number can build credit in the United States.
Your credit info is never merged with someone else’s, even when you are married. Spouses each have individual credit reports and scores, which is why it’s so important to build your credit history.
If you co-sign a loan or a credit card application with someone else, both of your credit scores are evaluated in the approval process.
So just to review, a credit score is simply a number representing a current evaluation of the data in your credit report. Because credit scores are based on your credit reports, it’s critical to know what’s in those reports.
And we’ll cover how to do that. But first, in the next chapter, we will cover the surprising ways credit affects the financial life that you should know.
1.3. Surprising Ways Credit Affects Your Finances
If your goal is to build credit so you can qualify for a mortgage or other large loan, that’s terrific. As we covered in the previous chapter, the better your credit rating, the more favorable you appear to potential lenders. Having higher credit scores allows you to get approved for the best terms and the lowest interest rates.
But besides cutting your interest rates, have you ever wanted to cut other expenses such as auto insurance, home insurance utilities, and cell phones? If you answered yes, and I’m sure you did, this chapter is for you.
Many people don’t understand that credit affects many aspects of your everyday life, even if you don’t borrow money.
Various companies and industries use credit to evaluate you even though they are not giving you a loan or credit card.
In this chapter, I’ll review 6 perhaps surprising ways that credit affects your finances, even when you don’t borrow money:
1.3.1. Employment
Employers in most states have the right to check your credit reports with your permission. Although the credit report available to employers is slightly different from the version a potential lender can see, it can still reveal any financial problems you might have.
Checking your credit is common for certain jobs and industries, such as working in finance or upper management. And it’s becoming a wider use practice for all types of jobs screenings.
The idea is that if you have a poor credit history, you might not be disciplined or responsible for handling money. Employers may fear that you have the potential to steal or be distracted at work due to financial troubles and not offer you a job.
1.3.2. Renting an apartment or home
Most landlords, property managers, and leasing companies check your credit as part of the application process to make sure you’re likely to pay rent on time.
If you have poor credit, you may get turned down to lease or have to pay a larger security deposit.
1.3.3. Cell phone contracts
Cell phone companies check your credit when you apply for a new account to make sure you will pay their bill.
If you have poor credit, you may be charged a higher rate, a higher security deposit, and not qualify for top-tier wireless plan offers.
1.3.4. Utilities
Credit also plays a big role in water, gas, power, and cable service.
You may have to pay a hefty security deposit, get someone with good credit to co-sign your application, or get a letter of guarantee from someone who says they will pay your utility bill if you don’t.
1.3.5. Auto insurance
Auto insurance is regulated by states, so the rating rules vary depending on where you live. Well, no state allows credit to be the only factor in setting auto insurance rates.
A few states have banned its use completely. Those are California, Hawaii, and Massachusetts.
But, most of the auto insurers and the remaining 47 states do factor credit into rates. Be aware that many other variables come into play, including your driving record, annual mileage, and vehicle model.
But, studies find insurance industry regulators, universities, insurance companies, and independent auditors have shown that consumers with good credit file fewer insurance claims and therefore are less risky customers.
1.3.6. Home insurance
Like auto insurance, home insurers also use your credit when setting rates for home, condo, and renters’ policies. Again, no state allows credit to be the sole factor in setting home insurance rates.
It is prohibited in California, Maryland, and Massachusetts. Both auto and home insurers use a credit-based insurance score different from a regular credit score like FICO or VantageScore.
Both use info in your credit reports; however, they are trying to forecast different things. Insurance scores aim to predict your likelihood of having an insurance loss, while credit scores For-profit predict how likely you are to repay a debt.
Unlike a regular credit score, you don’t have access to an insurance score because no standard model is used by all insures or credit agencies. Insurance companies don’t let the public know precisely how they use your credit to set rates because underwriting methods are highly guarded in the industry.
It is not a complete list of how credit affects your finances, but they are the most common and often pretty eye-opening.
The main thing to remember is that when you build credit, not only do you become eligible for credit accounts, but you save money and improve your overall financial life in multiple ways.
In the next chapter, I’ll give you some examples that show exactly how much having good credit means for your wallet.
1.4. How Much Good Credit Saves You
So far in this guide, you’ve learned that credit scores are important because having poor credit is expensive.
This chapter will give you a few examples demonstrating how much money you can save by having good credit.
Let’s say you’re in the market to buy a home and are shopping for a $200,000 mortgage with fixed payments over a 30-year term. If the going mortgage interest rate is 4.5% for applicants with good credit and 5.5% for those with average credit, you will pay almost $45,000 more over the life of the loan for having subpar credit.
Your credit status would cost you about $125 per month. Just think about what you could do and accomplish with $125 every month. If you invested that amount for 20 years at an average return, you’d have over $65,000, and the bigger the loan, the more interest is at stake for you to save.
If you don’t want to make a big purchase such as a home, consider a lower price auto loan. If you have excellent credit, you’re likely to qualify for a low-interest rate—even 0% in some cases.
Let’s say you want to buy a car that costs $30,000. Financing it over 5 years and a 6% interest rate instead of a 3% interest rate means that you pay $2500 more in interest. Your monthly payment would be $40 higher each month than if you qualified for a lower rate.
And remember that if you have poor credit, you might be turned down for a car loan altogether or have to pay a double-digit interest rate.
But don’t fall into the trap of thinking that credit only matters if you’re applying for a mortgage or car loan. As we covered in the previous chapter, having good credit means that you pay less for insurance on your car and your home, except in a few states where credit cannot be a factor in setting insurance rates.
Studies show that homeowners with poor credit pay an average of 114% more than those with excellent credit. And homeowners with fair credit pay 36% more.
According to the Insurance Info Institute, homeowners’ average annual premium in 2015 was $1173. That means having poor credit could cause you to pay an additional $1300 per year.
And for drivers with poor credit, auto insurance premiums cost an average of 104% more than for drivers with excellent credit. Even having fair credit means you pay 28% more than someone with excellent credit.
In 2015 the average annual auto insurance premium was $889. Those with poor credit ended up shelling out an additional $925 per year. Again, think about what you could do with that level of annual savings.
And if I haven’t already made my point, having good credit helps you keep more of your hard-earned money. Did you know that it can also help you earn more?
I’ve mentioned that many employers check prospective employee credit reports before making hiring decisions. You could get turned down for your dream job if you have a credit report that makes you appear irresponsible with money.
So, the bottom line is that good credit puts money in your pocket, and that allows you to improve your entire financial life by paying off debt faster, saving for emergencies, and investing more for retirement.
What’s next?
Now that you know what your credit is, it’s time to move on to the next step: understanding what actually goes into calculating your credit score, also known as “credit Score Reports”.
Click on the “Chapter 2″ link below to check out what credit factors make up your credit score, and how those factors are weighted in terms of importance.