Chapter 7: Credit Basics

Credit Records

Before granting you credit, a creditor will check into your past credit performance: Did you pay your bills on time? How much total credit did you receive? How much do you owe now and how large are your payments? They will run a credit report and get your credit score. They may call references.

Conditions

What affects your ability to repay the debt? There may be "external" conditions that affect your ability to repay a debt. Therefore, creditors want to know the following: How secure is your job? How secure is the firm for which you work? How is the employment situation in your geographic location and in your occupation? How can Guido get hold of you in a hurry?

Collateral

What assets are pledged to support the debt? Collateral is property pledged to assure repayment of a loan, such as the house, car, or furniture being purchased. Collateral protects creditors, making them more willing to lend to you. If you do not repay your debt as agreed, they can sell the collateral to collect on the debt. Note: Lenders cannot make loans based solely on collateral --that is illegal. Loans must be based on borrower's wherewithal to pay.

Credit History

Your credit history is the complete record of your borrowing and repayment performance. This record will provide answers to these questions and thus help the creditor determine your ability to pay new debts. In some cases, in can determine whether you are going to get a loan and the interest rate you are offered.

Parties to Debt

a debtor is a person who borrows money from others. In order to receive funds, a debtor must be qualified to receive credit. The debtor receives money, called debt, which must/should/could be repaid. A creditor is a person or business that loans money to others. Creditors charge money for this service in the form of interest and fees.

Creditworthiness

Before potential creditors will grant credit to you, they must determine whether you are a good risk -- that you are credit worthy. A person who is considered creditworthy usually meets five basic qualifications, called the five Cs of credit: Character, Collateral, Capacity, Capital, Conditions.

Capacity

Can you repay the debt? The financial ability to repay a loan with present income is known as capacity. Before lending you money, creditors want to make certain that your income is sufficient to cover your current expenses each month plus the payments on the new loan.

Character

Character refers to whether you will repay the debt. Character is a responsible attitude toward honoring obligations, often judged on evidence in the person's credit history. Creditors often use stability as a measure of character as well.

Capital

Do you have sufficient assets to support the debt? Capital refers to financial assets (bank accounts, investments, and property) you possess that are worth more than your debts. When you add up all that you own (assets) and subtract all that you owe (liabilities), the difference (net worth or capital) should be sufficient to ensure payment of your debt.

Fixed Rate vs Variable Rates

Fixed rates do not change for the life of the loan or debt. Interest rate risk is on the lender, ex: 30 year mortgages, car loans. Variable rates change according to a prescribed methodology. Sometimes variable rates are tied to broadly-defined, published rates. Example: LIBOR, US Prime, Treasury Rate. As these rates changes, your borrowing rate changes. Therefore, the interest rate risk falls on the borrower.

Credit Repayment Methodologies

Interest & Principal - aka "installment debt," think mortgages Interest only, then balloon - typically investment real estate, balloons can explode, usually relying on refinancing the balloon. Principal only - 0% auto or furniture loans. The interest is being made up somewhere. If you cant figure it out, you are a sucker.

Major Types of Credit

Mortgages, Credit Cards (average of $5000 per household, 40% rollover debt monthly), Student loans ($26,000 average for recent grads), HELOCs & HE loans, Auto loans (now pushed out for 6 or 7 years to entice people to buy more car than they can afford, and Personal Loans. Shortened list: Mortgage, Credit Cards, Student Loans, HELOCs & HE loans, Auto Loans, Personal Loans.

Credit Repayment Terms

Principal - amount borrowed Finance Charge - fees & interest, known as "the vig" Grace period - time between incurring the debt and repayment (or initial repayment) begins Terms of debt - when do repayments have to be made, and over what period.

Pros & Cons of Debt

Pros: Purchasing power that the current condition does not provide, access to security through certain methodologies (ex: credit card), establishing further credit, access to funds in an emergency. Cons: stealing your identity or credit capacity, fees & interest increase costs of purchases, reduction of future buying power, overspending, stress, bad stress, bankruptcy.

Secured Debt vs Unsecured Debt

Secured loans provide your lender with a claim on something you own, usually the asset they gave you credit to purchase. This is usually referred to as "collateral" and can be a house or a car. Secured loans are safer for the lender, which allows for lower interest rates. Less risk = lower interest rate. Unsecured loans do not require any collateral from the borrower. Therefore, the lender has less protection if the loan goes unpaid, therefore unsecured loans always have higher interest rates than secured loans. Because of this, they sometimes require a co-signer.

Term Loans vs Open-ended Credit

Term loans are money lent for a fixed period. You can decide to pay off term loans sooner, if you would like it. Open-ended, sometimes called revolving credit, allows you to continually have access to credit, as long as you comply with the terms of the agreement.

Credit

the use of someone else's money, borrowed now with the agreement to pay it back later. Credit is a necessary evil. Economics do not grow without available credit. People's lives are diminished without access to credit, especially in the early part of their lives. In order to make a honest wage, you are going to have to take on debt so that you can get an education, which allows you to gain the skills necessary to have such a wage.