Did you learn about credit and how important it is in high school? Me neither.
Your financial life depends on your creditworthiness.
Consumer credit is not a new invention but the internet and digital technology have enhanced the ability for lenders to know your creditworthiness. Assessing credit is big business.
We all have a difficult relationship with credit and talking about money. The truth is at some point in our lives, we are likely to need to borrow for a car, college education, or to buy a home. And some of us need to borrow to pay down older debts and get out of trouble.
Before you make big buying decisions, it is a good idea to know if you are creditworthy enough to borrow at low enough interest rates before you actually need to borrow.
Even if you are not in the market for a home yet, it is a good habit to see where you stand financially, review at your credit report to see if there are any errors and take action.
I will walk you through the steps you can take if there are issues on your report and reporting them to the three credit bureaus: Experian, Equifax and TransUnion But first let’s consider how lenders may consider you, the borrower and if they will lend you money.
How lenders look at our credit
Our credit scores are the number generated by FICO’s proprietary formula that put us in a range of good or bad credit. That score is based on a ton of accurate (or possibly inaccurate) information collected from banks and our financial lives that reflect on how we treat our money.
Lenders look carefully at our credit report and scores (discussed below) but to do their credit analysis They also look very closely at five C’s for households (eg mortgages) and business loans. The 5 C’s are The characteristics of credit—character, capacity, capital, collateral, and conditions—that form a framework used by lenders to evaluate potential borrowers. They look at quantitative and qualitative factors.
Character. As prospective customers, the bankers want to understand us as well as our credit history. They will profile us as far as our education, job, family, whether we are honest and if we have integrity. Are we forthcoming in disclosing possible missteps such as criminal actions, whether we have delinquencies or a low credit score that we need to explain clearly.
Capacity. Lenders want to know if we can pay our loans based on current cash flow. If we have other loans, how are we managing it. They will look at our budget , how much cash flow we have to pay for expenses, whether we are looking for loan for our household or a business. They will crunch numbers. With that in mind, it is a good idea to do some of the gruntwork ahead of time. Have we been keeping expenses under control relative to our income?
Capital. They will look at your personal investment in the home or small business you are hoping to get credit for. Bankers are more cautious about lending 90%+ to the borrower since the financial crisis when bankers were overly flexible. Those poor practices by the lenders then were in sharp contrast to traditional practices of requiring borrowers to put a minimum of 20% down payment on home purchases. Lenders are looking at what your “skin in the game” is. The larger the personal Investment, the lesser the chance of default.
Collateral. Secured loans typically have lower interest rates than unsecured loans. Lenders will look at what the asset or the colllateral you are willing to put up when asking for the loan. A loan secured or backed by an asset is easier to get whether it is for a home, car, or a small business that may have some real estate or intellectual property.
The value of the collateral may result in a lower interest rate, all else being equal.
Conditions. The conditions refer to the composition of loan (amount of down payment, type of interest rate), and what is the borrower using the loan for. The lender will also take into account what are the external factors such as economy, industry. If it’s a loan for a business, what are the industry conditions of the borrowers’s jobs.
Do the borrowers work in volatile or cyclical businesses where job layoffs are common in weakening economies?
Seven reasons you need your credit Report and scores
1. Know where you stand before you need financial decisions.
Like a grade on a difficult exam, you can improve your scores once you understand your report. Your scores are not static so you need to check your scores often.
Additionally, I recommend to parents that they should check their teens’s credit report by age 16 if their teen is an authorized user on their credit cards.
2. Buying a home. For most of us, our home is our largest and most important asset. You will need a FICO Score for a mortgage lender. An excellent score (over 720) will afford you relatively attractive annual percentage rate (APR). The difference in scores 600-720 could mean about 100 basis point difference in your APR or $70,000 in added interest costs.
3. Car loans and leases. Getting a car may be the first time you need credit. You will need your credit score for either a lease or loan. You need to understand the difference between a car lease and a car loan because creditors treat them differently.
The difference between leasing and a loan. Leasing a car pays for the depreciation of the car during the time of your lease. You don’t own the car at the end of the lease so it is not an asset (unless you buy it then for an incremental cost).
A car loan is more expensive than a car lease assuming similar time periods because you are paying for the entire car and is an asset. A 36 month car loan based on 600-680 credit score could be a 7% (not a typo) difference in your interest rate. Your lower score can add 10% to the cost of your car.
4. College loans. This is a big category and needs its own space. Parents may be footing part of the bill with a loan or you, the college student, may be paying for part or all the cost with a loan. Whether you are financing your own schooling or refinancing your loan, you will likely need your score. There are a lot of options between an excellent credit score, bad credit score and no credit score.
5. Check for mistakes, identity theft and fraud. An FTC study found that 20% of Americans have errors on their credit reports, and for a quarter of this group, the errors are large enough to hurt your ability to get a loan. That’s significant enough for me but add that to rising identity theft and fraud (up 8% annually), especially for the young, would be an incentive to routinely check your score.
Read our post on 9 Ways To Better Protect Your Privacy Against Fraud and Scams
6. Getting a job. I recently spoke to a Human Resources Officer at a major bank, and she shared that a credit check is part of the screening and is requested for all new job applicants. Employers are looking to reduce their risk in hiring practices.
They are scrutinizing their character, financial distress such as late payments and responsibilities. They don’t see scores but a modified version of your credit report.
7. Renting an apartment. Landlords have access to credit checks of prospective tenants through landlord associations and tenant screening services, and will pass on the fee for the process via the tenant’s application. Landlords are looking for red flags, notably bankruptcy filing, late payments, evictions, accounts in collection, car repossessions, minimum payments on credit cards.
If you haven’t already, review your credit reports and scores for where you stand financially
Now that it is established that you need your credit report score, where do you get it? And when I have it what does it mean?
Reviewing your credit report from the three major credit bureaus—Equifax, Experian and TransUnion— is a good place to start, easy and free. The scores of these credit bureaus do vary. You can go to the government authorized Annual Credit Report to get your free reports from each credit bureau. You have the ability to get reports from each reporting agency on an annual basis. You can get a free report from a different bureau every four months and stay in touch with your score.
An app like Credit Sesame gives you the ability to get your score for free, give you alerts to any changes in your score, and more.
The two major scoring systems are FICO Credit Score and VantageScore. The latter is a joint venture of the three credit bureaus.
FICO scores are still “The Score”
FICO Scores have been around longer than VantageScore, and better known with 90% of the largest lenders. Vantage’s scores used by 80% of 25 largest lenders are being reported with FICO scores though they differ in methodologies and weightings of what is counted.
Looking at the weight of different critieria gives an idea how to raise your scores, FICO Scores formula are calculated as:
Payment history: 35% of total score
Credit Utilization: 30%
Credit History: 15%
Credit Mix: 10%
New Credit: 10%
Are We Americans Bloated Debt-Wise?
As Americans, we are often characterized as being consumption addicted, debt lovers or debt-laden compared to the rest of the world. Certainly, $21.9 trillion in national debt at this writing, is no mere pittance. On a per capita (per person) review of countries, the US at $61,539, lands in the middle of 26 OECD (Organisation for Economic Co-operation and Development) countries, and below Japan’s $90,345, the highest of the group. We do need to do better on the kind of credit we, as Americans and as individuals, have. As Americans we are created equal but all debt is not equal. Low cost long term mortgages are better than high cost credit card debt.
We actually have higher proportion of credit card debt at 29.3% of total debt, versus about 20% for OECD countries.
How Do Our Credit Scores Look By Age and Income
FICO Scores range from 350-850, with 720 and above in the excellent range and 499 and below in the very poor.
The bulk of us are in the 620-719 score range.
About 14% of us do not have credit scores. That means we have no credit history and/or have not borrowed any money in the last seven years. FICO recently reported an all time high average of 704 score in September 2018.
The mean score has steadily climbed since the worst of our Great Recession in 2008-2009.
Looking at the Minneapolis Federal Reserve report and ValuePenguin, credit scores have been increasing by age and income factors which makes sense.
While we may assume that wealthy would be expected to have higher scores as an income group because of having greater resources, it is not necessarily a given. Income is actually not a factor in the scoring income algorithms per a recent Federal Reserve study.
By that same token, those with more modest means often do great financial management of the fewer dollars they have. More studies needs to be done on income levels and credit. Nevertheless, it is encouraging that the high scores are higher while the low end of the credit scores also increased.
According to Deloitte Insights Study on the Return of Debt, 56.8% of all mortgage originations were held by those with very high credit scores of 760+ while only 9.7% of those in the lower 620-659 got mortgages.
While your credit score is important to the lenders, there are several factors that lenders will look at when deciding to lend money. Those five C’s are added dimensions to our financial picture.
Have you been building your creditworthiness? How are you doing it? Please share your comments.
Look forward to hearing from you!
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.