“Debit or Credit?” is the question that you hear when you go to checkout at your favorite store, but what is credit, and how do you get it? I’d like to think of credit as a contract of trust that you have with another entity. Credit is a relationship, but the relationship involves the use and trade of collateral, mainly in the form or money. Think to some of your strongest relationships with family, friends, spouses, co-workers, how did it get so strong? Most would say though years and years of proximity, history, and building of a foundation of trust.
Trust is the paramount key to credit existing. If the lender could not trust in the ability of the borrower to repay, then the creditor/lender would not lend the collateral to the borrower. This trust is only built through consistency in borrowing and repaying amounts in a timely fashion while being careful not overextend the creditor’s/lender’s generosity.
Theoretically, let’s think of a neighbor who borrows your snow shovel during a snowstorm, and uses it to clear snow from their property. Let’s then say that the neighbor never returns the shovel to you, and upon the next snowstorm asks you for a shovel to use again. Would you lend that neighbor another shovel? Many people would not because that neighbor has impaired the trust of the relationship by not returning the shovel in time. The neighbor/borrower essentially now has bad credit due to the failure to repay. Our credit rating system in the US, attempts to capture our history of transactions in a credit file, and those transactions are rated using a credit score.
The credit score is an assessed value used to determine how well a borrower has historically performed in the ability to maintain trusting relationships with their lenders/creditors.What goes into your credit score?
There are five main areas of the credit score
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- New Credit (10%)
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- Length of Credit History (15%)
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- Payment History (35%)
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- Amount Owned (Credit Usage) (30%)
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- Credit Mix (10%)
New Credit – Consists of new applications for new credit, which are displayed as inquires. Inquires meaning that your credit file is being viewed to determine eligibility for credit. There are two types of inquires (Hard, and Soft). Hard inquiries are applications by the borrower for a potential new account or (relationship with new creditor). Soft inquiries are views of your credit file by lenders soliciting you to potentially offer you credit, or when your score/credit file is view for informational purposes (i.e. to review credit file, to determine credit score). Hard Inquires stay on your credit for 2 years, and impact your credit score. Soft inquires on the other hand, do not impact your credit score.
Recommendations: Keep credit inquires low (<3 per year) while establishing credit to develop, and maintain a good credit score. Just as when borrowing from friends, attempting to borrow from many people at once can cause concern for the lenders/creditor, as it causes them to wonder if there is eminent or current financial difficulty (You don’t not want to appear desperate for credit).
Length of Credit History – This is literally the oldest credit line on your file.
Recommendations: For many of us, there is not much you can do here but just keep getting older. There are some tools if you want to build credit for your offspring and they are of age which is >17 in most states, you could name them as on authorized user on your oldest account. The latter will allow them to piggyback your oldest line and history into their file. I will be doing this for my children; but, I’m definitely not going to say I did it.
Payment History – refers to your ability to make payments on time as simple as that (< 30 days late). This makes up 35% of your credit score so that this must be done in order to have and maintain a good credit rating.
Recommendations: Pay your bills on time. If you are going to be late, ensure that you are no more than 30 days late.
Amount Owed – I am not going to state the obvious here meaning of the words here, but this also entails the revolving credit utilization ratio which is an important factor in determining your credit score. The Amounts Owed makes up 30% of your credit score
Recommendations: While for the overall amounts owed (installment loans, and revolving credit) the 28:36 rule should be employed. The credit utilization should be kept below 20% of available credit. The credit utilization ratio is calculation performed to determine how close you are to your credit limits on your revolving credit cards. In order to maintain a high credit score this ratio must be kept in the lower ranges.
Examples of Credit utilization ratio
Jacoby has an American express card with a limit of $10,000. It currently has a balance of $2,000. Jacoby also has a Discover Card with a credit limit of $3,000 and presently has a balance of $300.
Jacoby’s credit utilization ratio is as follows:
For the American Express Card $2,000/$10,000 = 20%
For the Discover Card $300/$3,000 = 10%
Jacoby’s current overall credit utilization ratio is $2,300/$13,000 = 17.6%
Sarah has a Wells Fargo Credit card with a limit of $20,000 . It currently has a balance of $15,000. Sarah also has a Discover Card with a credit limit of $3,000 and presently has a balance of $2,000. Sarah has an additional Capital One Venture card with a credit limit of $20,000 with a balance of $10,000.
Sarah’s credit utilization ratio is as follows:
For the Wells Fargo Credit Card $15,000/$20,000 = 75%
For the Discover Card $2,000/$3,000 = 66.7%
For the Capital One Venture Card $10,000/$20,000 = 50%
Sarah’s current overall credit utilization ratio is $27,000/$43,000 = 62.7%
The conclusion is that Sarah’s credit score will most likely be impaired due to her high credit utilization ratio. Additionally, Sarah may have difficulty obtaining other cards due to her high ratio as well.
Credit Mix – Mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans makes up 10% of your score. If you’re a millennial you most likely won’t have a problem here due to our student loans.
Recommendations: similar to length of credit history, this will get better as you go through life and acquire things such as cars, homes through the use of loans and borrowing. Take your time and don’t read into this area too much.
Final Words: If you’re building, or rebuilding your credit, I recommend playing offense by opening up a secured credit card. A secured credit card is type of credit card that is permitted by a deposit provided by you to the bank. For example, if you provided a bank with a $300 dollar deposit for a secured credit card, you would receive a credit card with a limit of $300 dollars (the $300 dollars is refundable if the account is closed with a $0 dollar balance or it is converted to an unsecured card). The account is often converted to an unsecured account if you maintain a low credit utilization ratio and pay on time.
My favorite is the Capital One Secured Credit Card because it provides you with a credit score, and it does not charge an annual fee. Be sure to not carry a balance as it carries an interest rate of 24.99%. I recommend doing this by setting up a small recurring bill such as Netflix ($7.99 per month) to be paid by the secured card, and then setting up the Secured card bill to be automatically paid on receipt. In 12 months – 18 months with some defense, which I will delve into later, you will be happy with your score’s improvement.
For defense, review your credit file diligently to get rid of mistakes and errors, which can impact your score. Your credit score can be pulled once a year per federal law from www.annualcreditreport.com.
Cheers to wealth and health,
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