All About Credit

What Is The Cost of Credit?

Credit Comes With a Price: Interest Rate Charges

Banks and other lenders are willing to give you credit in exchange for interest rate charges on the "credit amount" that you borrow.

For example: let's say you need to borrow $1,000. The lender agrees to give you credit for $1,000 under an agreement that you will repay the borrowed amount in full after one year at an annual interest rate charge of 10%.

At the end of the year, you will need to repay the debt of $1,000 and interest rate charges of $100 for the use of the money. Your total repayment will be: $1,100.

 

Most Credit Plans Use Repayment Terms of 3, 5, and Even 10 Years or More

Home mortgage repayment plans can be as high as 30 years or more.

Lenders will use "amortization schedules" when setting up credit repayment plans. The "amortization schedule" calculates how much each month you will need to pay in order to reduce your borrowed amount with interest charges to zero over the repayment term of the loan.

You can use our sample calculators to estimate monthly repayment amounts.

You can also download FREE this amortization schedule worksheet to calculate and analyze loan repayment plans: click here

Applying for Credit

Lenders (or creditors) generally make an evaluation on your "application for credit" using three criteria known as the "three Cs":

• Character:
  the measurement of your "willingness" to repay the debt (measured by your past credit experiences, length of employment, length of residence, etc.)
• Capacity:
  the measurement of your "ability" to repay the debt (measured by your employment, income, current outstanding debts, monthly expenses, etc.).
• Collateral:
  the measurement of available "resources" that the lender can assume in the event that you fail to repay the debt (savings, property or investment).

 

Using the "Three Cs"

Creditors will ofter merge the "Three Cs" into sophisticated computerized models to help them determine whether to grant or deny you credit.

A credit scoring system awards points for each factor that predicts who is most likely to repay a debt. Using statistical programs, creditors compare your information to the credit performance of consumers with similar profiles.

A total number of points — a credit score — helps predict how credit worthy you are, that is, how likely it is that you will repay a loan and make the payments when due.

Tell Me More About Credit Scoring

The Credit Score is a Numeric Scoring System

Lenders use the score to speed up the loan process and provide an unbiased assessment of your loan application.

Although lenders and credit agencies have their own proprietary scoring systems, the most common scoring model used among lenders and agencies for consistency is the Fair Issac Company (FICO) model.

You can find more information about the Fair Issac Company.

 

FICO Will Grade Your Risk By Analyzing the Following Credit Factors:

• Your Payment History:
  analyzes your payment of debts, whether they are delinquent or late
  
• Your Amount of Outstanding Debt:
  considers the number of balances recently reported, the average balance among all credit lines or loans, and the relationship between the total balance and total credit limit.
• Your Credit History:
  looks at the history of your accounts, the total number of "inquiries" made and new accounts opened over a period of time
• The Types of Credit:
  looks at the type of credit you use such as mortgage loans, personal loans, credit cards, retail cards, travel cards, etc.
• Negative Information:
  looks for bankruptcies, delinquencies or late payments, collections, too many credit lines charged to the maximum limit.
  
  These credit factors are compiled into sophisticated models that have analyzed credit behavior over the years. It generates a score, which in theory states that, the higher the credit score the less likely the lender is at risk that you will default on a loan.

 

Every Lender Has a Different Credit Tolerance Level.

One lender may reject your application because of a score while another lender approves it. Your score may be too low for one lending product but passes another.

Basically, the score lets the lender know how to treat your application. If your score falls below their minimum threshold, they may require additional information in order to make an approval decision. Again, score determination varies by lender.

For a range of FICO credit scores, see credit score

 

Let Us Emphasize One More Time:

It is extremely important to build a strong credit history over time. A strong credit history will give you favorable interest rates for home mortgages, consumer loans, consumer credit, business credit, and insurance.

And it is becoming more in use with employment. Many employers are using credit history as part of the application.

More information about credit scoring:
www.ftc.gov

Types of Credit

The most common type of "consumer-related" credit include the following. There is also business credit that will be not be addressed here:

Credit Cards:

The most common type of credit is the credit card. There are three types of cards:

1. Bank Cards:
   such as VISA, MasterCard, and Discover cards. These cards allow you to purchase from 3rd party establishments with the bank ensuring payment for the purchase.
2. Retail Charge Cards:
   such as Sears, JC Pennies, Exxon Gas, etc. These cards allow you to purchase items from the company that is issuing the card.
3. Travel and Entertainment Cards:
   such as American Express, Diners Club, and Carte Blanche.

 

Debit Cards:

A plastic card that allows you to purchase items on debit — meaning that your purchases are automatically deducted from your savings or money account:

1. Debit Cards:
   such as ATM cards that are part of the Novus®, Cirrus®, or other money networks. Purchases are automatically deducted from your account at the point-of-purchase.
2. Check Cards:
   ATM cards that are part of the VISA® or MasterCard® network. Purchases are deducted from your accounts over a 1-3 day period.
3. Pre-Paid Cards:
   stored value cards that are part of the VISA® or MasterCard® network. Consumers will load money to the card and use it like a credit card to make purchases.

 

Open Lines of Credit Plans:

An open line account allows repeated transactions up to the maximum credit limit.

You will pay a calculated amount (or some other amount greater than the minimum amount required) each month until the borrowed amount is repaid.

You can borrow an amount over again up to your available credit line limit.

Examples include credit cards, home equity lines of credit, and other open line accounts.

 

Closed Line of Credit Plans:

Commonly known as installment or personal loans. These plans will lend money at a fixed amount at the point of application and approval.

You will repay the amount with fixed monthly payments over a period of time.

Examples include auto loans, mortgage loans, and other fixed term loans.

 

Secured Loans:

Loans that require collateral that can be used to payoff the loan in the event the applicant fails to meet the debt obligations.

Mortgages, home equity, and auto loans are good examples of secured loans.

 

Unsecured Loans:

Loans that do not require collateral. These loans are made based on your credit score and ability to repay.

Examples include credit cards and unsecured credit lines and loans.