Myths On Money

Okay, I may be guilty of perpetuating a money myth. In my post you must use credit to get credit I am afraid I may have given the impression that the quality of your credit history and score is not an important consideration for lenders (see how easily these myths can spring up?). That was not the point of the post. The point of the post was to show how important it is to make sure your income exceeds your expenses by fair margin, and that by using credit heavily, you reduce your available income and thus hurt your credit worthiness in the eyes of lenders. However, your credit score is a very important factor in your life. It can affect your work, your insurance rates, and, of course, your credit worthiness.

Tricks of the Trade

Your credit score is a strange creature. The most bizarre things can hurt it, and even more bizarre things can improve it. Let’s take a look at some tricks of the credit scoring game.

1. Increase your credit limit. An important factor in your credit score is a ratio called the “debt utilization ratio”. This ratio is calculated by the following formula: 
   Debt Balance ÷ Available Debt
   For example, if you have two credit cards each with a credit limit of $2,000, then your available debt is $4,000.  If you have a balance of $300 on one card and $700 on the other, then your debt balance is $1,000.  This would give you a debt utilization ratio of $1,000 ÷ $4,000 = .25, or 25%.  Generally, the people who keep their debt utilization ratio around 10%-20% have the best credit scores. A low debt utilization ratio shows lenders that you use your credit wisely, not excessively.  Just make sure that you are making prompt payments!
2. Don’t wait for your bill to pay down your card. The credit card company reports the balance on your credit card to the credit reporting agencies at the time that they process your monthly bill. If you have a high balance at the time the bill is printed, then that is the balance that goes on your credit history, regardless of when you pay it off. So, if you have a high balance and pay it off after you get your bill, the high balance will still hurt you. Go check your card online and make payments on it, even when your bill has not been sent to you yet.
3. Keep a small balance on your card when your bill is processed. If you pay your credit card off comlpetely right before your credit card company sends you your bill, it will show a zero balance when they submit the bill to the credit reporting agencies. By keeping a balance on the card to show up on the bill, you how that you are using your credit, and by keeping that balance small you prove that you are using it wisely. After the bill has processed, immediately pay off the remaining balance so that you don’t have to pay any interest. A good strategy would be to make regular payments to your credit card and keeping the balance always below 20%, and making sure that you pay the full balance after your bill is printed. By doing this, you will improve your credit score quickly, and you won’t have to pay any interest.

Be Careful

What creditors are looking for in your credit score is evidence that you are in control of your own finances. If you cannot have a credit card and remain in control of yourself and your spending, then do not use credit cards. If you do, your lack of control over your finances will be evident and you will have a poor credit score. Be careful to not get carried away by credit, because it is very tempting to some. Don’t be fooled by the low payment the credit card requires. Always pay your card off in full each month, never ever pay interest on a credit card unless you absolutely must. Maintain control of yourself and your finances, keep a close watch on your credit history and your credit card balances, and watch your budget and expenses. If you do so, you will eventually find yourself living the lifestyle you have always wanted.

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.

The Word on the Street

There is a general opinion (fostered by aggressive advertising campaigns) that using credit will let the borrower have goods and services they could not otherwise afford, and thus improve their quality of life.

The Truth:

Credit, whether a mortgage, credit card, home equity loan, installment loan (ie making payments on a tv, washing machine, sofa, etc.) reduces your standard of living by taking money out of your pocket.

Doubt me? Let’s take a look at some very simple principles of credit and interest and see if I am right.

Credit Costs

Let’s stop for a moment and really think carefully about what credit is. Buying on credit means that someone else pays for your purchase, and then you pay them back for it. This is, of course, not a free service. The fee charged by credit companies is given a fancy name; they call it interest.

When you slap down a credit card, or get a new bed on installment payments, you are agreeing to pay more for the item than the sales price. Think about it: if you buy a $500 TV and pay cash, you will pay $500 for the TV, and no more. If you pay on credit, then you get the TV for $50/month for 12 months. $50/month x 12 months = $600. You just paid $600 for a TV that only cost $500 to begin with. You lost $100. So, while you may have the TV a few months before your friend (who paid cash), he will have not only a TV, but also a DVD player. So whose quality of life is higher? You, with your TV and $100 lost on interest, or your friend, with a TV and a $100 DVD player?

This is the great trick that marketers play on consumers. When was the last time you saw a car commercial where they told you the purchase price of the car? They are very rare. Why? Because the dealership doesn’t want you to pay for the car upfront; they want you to finance the car (or better yet, lease it!). They make much more money that way. Can you blame them? What if you were selling your car? Would you prefer $1000 up front, or payments of $200/month for 7 months? In some situations, you may need the cash immediatley, but if you can wait for the money and get an extra $400 for your patience, wouldn’t you do it? So the next time you are tempted to buy something on credit, just think: how much interest will I pay, and if I don’t pay interest, what could I do with that money instead?