Credit

What is a credit score?

The credit reporting agencies function as reporters. Their job is to gather information and report it out. The credit scoring systems are separate from the credit reporting agencies. The credit scoring companies take the information from the credit reports and compute a score using factors that weight the various elements in the credit report. Credit scores range from 300-850. The higher the score the more attractive you are as a borrower.

You may find that your credit score varies depending on which credit agency you have used. Some people obsess over what their credit score is, and overlook what the credit report indicates. The opposite is actually more important. Keep track of your credit report and make sure that the information being reported is accurate. Your credit score is a result of your credit report information.

Payment history—35%

How have you paid on your accounts? On time? Late? Anytime you pay a bill over 30 days late it is reported to the credit reporting agencies and can lower your credit score. You have to be over 30 days late for it to be reported so if you are only a few days late or a mistake is made it will not negatively affect you.

Amount owed—30%

How much do you owe compared to your credit limit? If you owe close to your limit on your credit cards then it can negatively affect your credit. It is a good rule of thumb to keep your credit cards below 67% of their limit and even better below 50%. If you have several credit cards that are near their limit or “maxed out” then it can look to the creditors as if you are overextended.

Length of credit history—15%

The more positive history you have, the better for your credit score. This is why it is important to start building positive credit history early on so you can demonstrate that over a long period of time you were responsible for your credit.

Opening new accounts—10%

If you open several new accounts in a short period of time it can send up a red flag because it can look like you are over extended and needing the money.

Types of credit accounts—10%

Showing a healthy balance of revolving credit, installment loans, mortgages and more can help show that you are capable of maintaining several different types of accounts responsibly.

What if I have a good credit score but make some mistakes?

Unfortunately, when you make credit mistakes you are subject to a lower credit score. Depending on how severe the mistake is, you may be facing a downgrade of 25 points to 240 points in your credit score! Check the list below to see how your credit can be affected if you don’t handle your finances responsibly.

Credit profile: Sasha

Sasha has always been frugal and has saved up her money for a down payment on a beautiful condo near her job. The condo will cost $250,000 and Sasha has saved enough to pay 20% down and all the fees associated with the sale. She visits the bank and finds out that she is approved for a loan for the remaining $200,000, and based upon her good credit, will only have to pay a 6% interest rate

Sasha is very happy until they tell her the monthly payment will be $1,200 for the next 30 years. She quickly multiplies $1,200 times 30 years times 12 months in a year and it comes to $432,000 to pay off a $200,000 loan! How can this be?

Sasha would like to calculate this out for herself, but does not understand how interest works. Let’s work through the first month’s payment and see how this works.

Annual interest rate = 6%/year. The monthly interest rate (annual rate /12) is: ______

How much interest is included in her first payment: (monthly interest rate x $200,000): ______

How much of her first payment goes to pay off the loan (payment—interest): ______

How would you calculate the second month?

How interest works:

Like Sasha, if you were buying a house you might need to borrow $200,000 or more through a home mortgage (loan) from a bank or credit union. In order to make the monthly payment on the loan affordable, individuals usually take 30 years to repay it. Based upon this, the bank would determine the interest rate you need to pay (6% in this example) and would calculate your monthly payment ($1,199.10).

Every month, you would pay this amount to the bank or credit union. At first, the payment would almost entirely be for the interest, but over time you would gradually reduce the amount you owe the mortgage company (loan balance). Because the amount you owe decreases over time, the amount of interest in each payment also decreases.

The following table shows how this would work with the above example. In general, it takes about € 2 3 the length of the mortgage to pay off half of the original loan amount. You will also notice that you pay more in interest than the original loan. Getting the best interest rate possible (largely determined by your credit score) is important to reduce the amount of interest and your monthly payment.

Time                     Total Paid                           Total Interest                    Loan Balance

5 years                $71,946                               $58,055                            $186,109

21 years              $302,173                            $202,051                          $99,877                       

30 years              $431,676                            $231,676                          $0

Example of the impact of interest

Let’s use the example of buying a new car. Assume the car will cost $20,000 and you want a loan to pay for it over three years. Your credit score will have a great impact upon the interest rate that you will pay on this loan. If you have a lower score, you will pay a much higher interest rate. This, in turn, means a higher monthly payment and you will pay much more over the course of the three years. In the following example, a person with excellent credit will pay $1,901 in interest over three years while a person with poor credit will pay $6,290.

3 Year - Auto Loan - $20,000

   FICO Score                Interest Rate                Monthly Payment                Total Interest Paid

                  720-850                           6%                                     $608                                       $1,901        

                  690-719                           7.6%                                  $623                                      $2,430                                 

                  660-689                           9.6%                                  $642                                       $3,096

                  620-659                           13.4%                                $678                                       $4,391

                  590-619                           18.1%                                $724                                       $6,077

                  500-589                           18.7%                                $730                                       $6,290

Payday loans

Payday loans are essentially short-term loans. You write a check for the loan to the payday lender, they hold it until a specified time in the future and then cash the check. Payday loans were originally set up to help people who needed emergency money before their next paycheck. Because their credit rating was poor, they often could not get a loan from a bank. Instead of going to a loan shark, they were able to go to a payday loan outlet and get a very short-term loan to help them until their next paycheck.

Interest rates and fees were very high, but if used in a true emergency, it was a valuable service. The difficulty for some people is that they get in the habit of obtaining loans on a regular basis. Each loan renewal covers their previous loan and they are locked into a cycle of increasing debt and very high fees.

 In 2007, Oregon law was changed and set the maximum interest rate a company can charge at 36% per year, with loan fees of 10% of the loan amount up to a maximum of $30. In Washington, the maximum fee is 15% on the first $500 and 10% above $500. Note this is a fee and not an annual percentage rate.

Successfully managing a credit card account is an important skill that will help you manage your financial future. Used improperly, credit cards can tie you down with high monthly payments that will prevent you from realizing your dreams. Used properly, they can help you achieve them. Credit cards simplify purchase transactions, provide protection from financial fraud, and help build your credit score. Still, being responsible for a credit card leads many down the path of temptation. Why wait to buy something until you have the money when you can have it now by “charging it?”.

A good rule of thumb to live by is “you have to make a plan for paying off debt before acquiring it”. It’s important to understand the true cost of items after interest is charged and how racking up too much credit card debt can take you down a path that leads to great frustration and financial ruin.

What if I make the minimum payment on my credit card?

The minimum payment is the least amount you must pay each month to avoid a late fee and keep the account in good standing. Legislation that went into effect in 2010 requires credit card companies to disclose how long it will take to pay off the balance if you just make the minimum payment. The tricky part of this legislation is that the information appears on the credit card statement. Many people do not look at the statement because they manage their accounts online. In order to find this information, you must log in and download your monthly statement in order to see how long it will take for you to pay off the balance if only making the minimum payment as well as what your total cost will end up being including interest. Paying only the minimum payment is one of the biggest mistakes people make with their credit because the minimum pays off very little of the actual balance on the card.

The minimum payment looks very appealing, especially to people who are just starting out. If you need a computer for school, for example, you could charge it on your credit card and then just make the minimum payment. This usually looks very affordable (generally interest plus 1% of the balance) and easily fits within your paycheck. But you will be paying for many years to come, since most of your payment goes to interest. As you charge more items in the future, the minimum payment will increase and you will lock yourself into a long-term debt cycle. Once again, always have a plan for paying off a debt, not just meeting the monthly payment.

Credit Profile: Steve

Steve cannot figure out why he is so far in debt. He graduated from high school, got a job at the local grocery store, and opened a credit card. Each month when he gets his bill, he always makes the minimum payment on time. Yet the balance on his card keeps growing. He is very frustrated and could use your help.

Steve’s credit card has an annual interest rate of 18%. The minimum payment is 4% of the current balance. Right now, Steve’s balance has grown to $2,500. Let’s see how the minimum payment helps Steve pay off his balance:

Minimum payment = 4% of the balance ($2,500) = __________

Monthly interest rate = Annual rate / 12 = __________

Interest for the month = Monthly interest x balance ($2,500) = __________

Credit card balance paid off = Minimum payment – monthly interest = __________

How long do you think it will take Steve to pay off this balance if he makes the minimum payment and charges nothing else?

How Can Steve Help Himself?

How much faster could we pay the debt off? The following table shows this purchase with the minimum payment, $150 per month, and $200 per month.

The difference in the total amount paid and the time to pay off the balance is amazing. By increasing the payment to $150, we decreased the time to pay off the loan by 5 1/2 years! The total amount paid is decreased by $890.

The key is to have a plan. If you cannot foresee when you are going to pay the item off, then you should ask yourself, “Do I really need to purchase this now on credit?”

Paying the minimum payment not only increases the total number of payments it takes to pay off the debt but it increases the real cost of the product significantly.

Credit Profile: Ava

Ava, 24, recently graduated from a state university. During her college years, Ava had four credit cards and used them to buy many items for which she could not afford. Often Ava was late with the payments on her card by a few days. A couple of times she missed payments entirely and paid it 60 days after it was due.

When Ava left college, she had combined balances of $3,000 on her credit cards.

Ava works at a bank, earning $50,000 a year. She learns that she could finance her own one-bedroom condominium for about the same amount she pays in rent each month.

Ava has a $30,000 inheritance from her grandmother that she can use as a down payment on a condo. After looking at places for a month or two, Ava finds a $125,000 condo that she wants to buy. She fills out all the paperwork required by the mortgage lender and waits to hear if she is going to get the home loan.

Do you think Ava will get her mortgage?

In what ways could Ava have handled her credit more responsibly?

Annual Percentage Rate (APR)—The APR is the rate of interest you are charged, expressed as a yearly rate. If you plan to keep a balance on your credit card account, you want to look for a low APR. If you expect to pay your bills in full each month, it will be more important to compare the annual fee and other charges.

Fixed-rate loan—The APR on a fixed-rate loan is set when the loan is opened and remains the same through the entire term of the loan and does not change when market indices or other interest rates fluctuate.

Variable-rate loan—The APR on a variable-rate loan can change when market indices or other interest rates fluctuate.

Finance charge—The finance charge is the cost of credit. It includes interest, service charges, and transaction fees. This charge is calculated on your balance using different methods.

Collateral—Assets pledged by a borrower to secure a loan or other credit.

Secured loan—A loan guaranteed by something of value (collateral) such as a house, automobile or securities. If you fail to pay the loan, the lender has the right to take the collateral.

Revolving credit—Open-ended loans allow an individual to borrow money over and over. A credit card would be an example of an revolving credit. You are being extended a line of credit, with a limit, that allows you to borrow money and pay it back periodically.

Installment loan—Closed-ended loans typically have an ending date (e.g., 5, 7, or 30 year loans). As a borrower you make payments that pay down the balance over the lifespan of the loan. If you need more credit you would have to apply for a new loan. Examples of closed-ended loans would be mortgages and car loans.

Unsecured loan—Unsecured loans do not require an asset to be used as collateral. The borrower’s credit history, score and income level are the usual determining factors as to whether they can take out this particular type of loan. Unsecured loans usually have a higher interest rate, because the lender is taking on more risk by lending out money without a collateral backing.

Conventional loan—Conventional loans are loans that are not guaranteed or insured by the federal government. The most common types of conventional loans are mortgages.

What is credit, how does it work, and why do you need it?

Credit is the ability to borrow money or obtain goods by paying little or no money at the time of purchase. Credit allows you to spread out payments over time for expensive items. Your credit history can affect you in a number of different ways: buying a home, getting a job, getting phone service, renting an apartment, financing an automobile, qualifying for insurance, and obtaining a credit card.

How can you establish credit?

Obtaining credit is much harder now than it has been in past years. In order for a new borrower to establish a credit account, you may have to look to a company you already have a relationship with, obtain a co-signer, or use a secured credit card.

What are your responsibilities as a borrower?

Borrow only what you can repay. People get into financial trouble when they borrow money and only focus on the monthly payment. In addition, you should read and understand the credit contract, pay debts promptly, notify your creditor if you cannot meet payments, and report lost or stolen credit cards promptly. Protect yourself from fraud by keeping your personal information secret.

How can you monitor your credit using a credit report and score?

Whenever you use credit, the creditor will most likely report information about you to the three major credit reporting agencies - Equifax, Experian and TransUnion. You can get a free copy of your credit report each year from each reporting agency at www.annualcreditreport.com.

Your credit score is based on the information in your credit report. The most commonly used score is compiled by the Fair Isaac Corporation (FICO). Your credit score is calculated based on the following:
payment history, the amount owed, length of credit history, opening new accounts, and types of credit accounts.

How do loans and credit cards work?

For a loan, the borrower initially receives or borrows an amount of money, called the principal, from the lender, and is obligated to repay an equal amount of money, plus interest, to the lender over time. Typically, the money is paid back in regular monthly payments.

Credit cards are revolving debt. You are approved for a credit limit. As you borrow and repay, you can borrow again up to the credit limit. The type of credit card you choose or for which you are approved will depend on your individual situation. A low minimum payment looks very appealing, especially to people who are just starting out, but you will be paying for many years to come since most of your payment goes towards interest.