Myth: You Must Use Credit to Get Credit

The Word on the Street

Everyone seems to believe that the only way to get good credit to qualify for a necessary loan (usually a mortgage), they have to use credit cards, get auto loans, etc in order to get a good interest rate on future loans.

The Truth

Your history of repaying debts is a relatively small portion of the considerations lenders make before offering to extend credit to a potential borrower. In short, a bad credit history can sink your hopes of getting a good loan, and a good credit history can certainly help, but a neutral (or non-existant) credit history will not preclude you from qualifying for a loan when it really matters because there are other, more important considerations.

Doubt me? Let’s take a look at the attributes and procedures used by lenders to determine a would-be borrower’s credit-worthiness.

The Three “C’s”

The only concern of the lender is your ability to repay the loan along with any related expenses. To assess this ability, lenders often look at the three C’s of credit:

Character

How you have handled yourself in previous financial dealings. This includes not only your credit history, but how reliably you have paid all of your financial obligations, including rent, utilities, alimony, etc. Your credit character helps the lender get an idea of whether or not you WILL repay the debt.

Capacity

Refers to your ability to repay debt out of your future income. Here, the lender looks not only at your income but also at future commitments that might restrict it. These commitments are almost always debts, although some commitments are non-debt related (such as alimony). Your credit capacity gives the lender an idea of whether or not you CAN repay the debt. This differs from the character portion of the analysis, where they simply want to see if you have been reliable in the past. In most cases, your credit capacity will be the most important factor that determines whether or not you qualify for a loan, for reasons that I hope will become obvious with an example.

Suppose you have the opportunity to loan money to one of two people. The first borrower, Jack, has a great credit history. He has carried lots of debt for a long time, and has never once failed to make his payments. The problem is, Jack spends most of his income on debt payments, and barely has enough extra income to make payments on your loan. The other borrower, Minnie, has only a small credit history. She has not debts whatsoever right now. A quick check show you that she has been very consistent in paying rent and utilities, indicating that she takes her financial obligations seriously despite having rarely incurred such obligations. She has plenty of money each month with which to repay you. Who would you give your money to? Personally, I would give it to Minnie because she actually has the ability to repay, and has not demonstrated a propensity for fiscal irresponsibility. Jack has managed his obligations well, but he has no wiggle room for your loan. The slightest mishap in his finances would cause him to lose the ability to repay you.

Capital

Refers to your financial strength, usually measured by net worth. Net worth is a financial term that simply means how much you own (assets) minus how much you owe (debts or liabilities). Essentially, this is a measure of how much money you would have left if you were to sell everything you own and repay all of your debts. This is an important consideration when looking at whether or not to lend money. If the borrower has extra funds or assets that he could potentially sell to repay the lender, then this reduces the risk that the lender will never get their money back in the event the borrower faces financial difficulty. Like the credit capacity rating, the credit capital rating measures whether or not you CAN repay the debt. As you can see, only one of the three factors considered above pertain to your credit history and whether or not you WILL repay the loan. The lender is much more concerned about whether or not you CAN repay the loan, as measured by the capacity and capital components of credit-worthiness. Notice also that use of past debt is only a portion of the character component. In essence, it might be said that your use of credit in the past constitutes less than 33% of the considerations made when you apply for a loan.

This is not to downplay the importance of the character component. Certainly, if you took a test and missed 33% of the questions, you might be a bit disappointed in your score(well, I guess it depends a bit on which subject the test covered….66% might be a great score for some classes!). But it is important to realize that you do not have to go into debt in order to satisfy the charcter requirements. By simply showing that you have handled your finances responsibly, you can satisfy the character component.

How can you build your character score without going into debt? First is to take care of your obligations. Everyone has financial obligations, even if they have no debt. Pay your rent, make your utility payments, pay your taxes (and on time!). Next, take advantage of the fact that the three components are very interrelated. Your character score can be much improved by simply taking care of your capacity and capital scores. Think about it; if you see someone who has taken on a great deal of debt, and has maxed out credit cards, would it surprise you to learn that they had been evicted several times from various apartments? It wouldn’t surprise me. What if you saw someone who had a wad of cash in savings and whose income far outstripped their living expenses? Would you consider that person likely to take care of their financial obligations? I certainly would, and I would be much more inclined to lend that person money even if they had no past history of repaying debts. That person has improved their capacity and captial scores to the point where few would doubt their willingness to pay off their debts. And that’s what lender’s really want, isn’t it?

Risk and Return

The topic of investment risk and investment return could occupy an entire college semester (I have, in fact, attended just such a class). For the purpose of this post, I will just touch lightly on this topic to help you get an idea of how and why banks charge higher interest rates to some people, and not to others.

It is one of the most, if not the absolute most, fundamental principles of investing that higher returns cannot be gained without taking greater risk. In the stock market, higher risk is usually found in the volatility of a given stock; the chance it might go up by a large amount is offset by the fact that it might also go down by a huge amount. This principle becomes intuitive when we pull it out of the financial arena and bring it home in terms we see every day.

Suppose you were in Las Vegas with $100 in hand, and were considering which game upon which to place your bet. In one game, the dealer draws a card from the deck. If the suit of the card is a spade or club, then you win $200. If it is a heart or diamond, you win nothing. In the other game, a giant wheel with 100 slots in it is spun. If it lands on the number you picked, you win $200. Which game would you play? You would play the card game because it gives you the best chance (50% compared to 1%) of winning the same prize. Now let’s change the scenario a bit. Suppose instead of winning $200 on the wheel game, you had a chance of winning $1 million dollars. Now which game would you choose? It’s a harder choice, isn’t it? The card game is far less risky (because you have a 50/50 chance of winning), but the wheel game has a far greater reward. You would expect the games to be structured more like this because it doesn’t make sense for you to take more risk for the same reward, when you could take less risk and still get the same reward. This is the relationship between risk and reward(return), and it holds true in Vegas just as easily as it holds true in the stock market, the bond market, or even the mortgage market.

You are an Investment

You need to keep in mind that when you apply for a loan, the lender is not looking at YOU and deciding if YOU can have the money or not. They are looking at an investment, pure and simple. They want to invest their money in you. If you are a risky investment (i.e. with a low chance of repaying), then they will want a greater return in order to justify investing in you. They get that return by offering you a higher interest rate than they would to someone who was “less risky”. That is why it is important to make yourself appear as though you can repay them. If you look like you can repay them, then you most certainly can because lenders are very thorough and will find out if you cannot repay. So, when trying to qualify for a great interest rate on a loan, just think about what YOU would want to see in someone that you were considering loaning money to. Chances are, your lender will be looking for much the same thing.

Posted on 12 Sep 2008