To build financial trust or credit you need to understand how the credit puzzle fits together. The creditor, the one loaning you the money, looks at most or all of these pieces before granting credit to you. Therefore knowing all the pieces before you start to use credit will be the key to becoming credit savvy.

Income is money that you are earning or the allowance you are given now. When you are extended credit, the creditor needs to determine if you have the financial capability to meet the loan payment schedule. The amount of income needed for a loan depends on the amount and type of the loan. For example if you are borrowing money for a house most creditors will require that your monthly payments not exceed 35% to 50% of your take-home income.

For credit purposes, character is measured by how you pay previous loans or debts. This information is available by way of a credit report. There are three major consumer credit reporting companies in the United States: Equifax, Experian and Trans Union. Creditors report the payment history of their loans to these credit-reporting companies. The credit reporting firms also collect information about other debts you may have. If you have your car repossessed, your homes foreclosed, bounced checks or file a bankruptcy then this information is also reported in the credit report. The information in your credit report is generally kept on file for two to ten years.

Stability is an estimate of how much your financial situation may change during the term of the loan. If your employment is unsteady or unlikely to continue, then the creditor may have concerns about your ability to meet loan payments. If your expenses will be increasing or your debts are expected to grow in the near future, then the creditor may also have concerns about your ability to meet loan payments.

Debts are how much money you currently owe other creditors. This includes credit cards, car loans, home loans, school loans, and all other loans. If you have lots of other loans or a high amount of outstanding debts then a creditor may have concerns. Most creditors have debt guidelines for different types of loans.

For example if your total current credit card debt exceeds 20% total income then you may be considered to have a maximum amount of credit card debt. For a home loan the maximum amount of debt could be as high as 200% to 300% of your total income.

Assets are how much money or value you have on hand. Assets include cash in the bank, savings accounts, certificates of deposit, bonds, stocks, etc. Assets also include cars, motorcycles, a house, or other valuable stuff. Creditors consider assets a safety net for a loan. In some cases creditors will require a certain asset to be listed as security for a loan. This is almost always true for car and home loans. However if a creditor determines you have sufficient assets to fall back on, then they feel more comfortable making a loan.

Expenses are the total of the bills you pay monthly or regularly. Expenses include regular costs for food, rooming, electricity, water, sewer, insurance, tuition, books, car gas, etc. Creditors need to be sure you have enough money left over each month after your expenses to make your loan payments.

The definition of good credit has changed significantly over the past two decades. Changes in the economy have lead to a change of consumers’ perception of money, and in turn, their spending habits. We now live in the day and age where we no longer see our funds leave our possession. Today we make payments via e-mail, debit transactions, automatic withdrawals, and of course, credit cards. Money is no longer perceived as a tool to maintain and better our lives, it is simply a number we see displayed on the screen at the ATM when we check our balances.

With the convenience of electronic commerce, It’s easy to apply this view to our credit card limits. However, be warned. A credit limit is simply a loan. Of course, once any of this limit is used for purchases, it must be paid back. Many consumers may not think of it this way when they use the credit line. This leads to many people becoming overextended and finding it harder and harder to keep up. In turn they begin to miss payments, pay less than the minimum requirements, or worst of all, file bankruptcy.

Twenty years ago creditors really had two levels of credit, “A” credit, and then everyone else. Those consumers who had “A” credit (in essence, perfect credit) received all the offers, and everyone else simply dealt with not having credit cards and not qualifying for many types of financing. Since then creditors have extended too much credit, which has lead to consumers’ current perception of money and therefore their difficulties paying it back. Today 70% of American consumers have less than ideal credit. This means that creditors have less people meeting their original guidelines for lending and have reassessed the way they lend.

As a result of all of this, creditors have changed the system they use to judge credit worthiness. Instead of just two classifications, they now divide credit applicants into several different levels (A, B, C and even D credit). The applicants with the best credit (“A”) receive better (lower) interest rates. As the consumer’s rating decreases, their interest rates increase. Though a consumer could have a “D” credit rating, they could still receive financing, but the interest rates of such financing are simply mind-boggling. It is not uncommon to see interest rates as high as 29% (we have seen higher). Let’s do the math. For the purposes of this example, we will use the following statistics:

• Consumer 1: “A” credit, 6% interest, $2,500 balance
• Consumer 2: “D” credit, 29% interest, $2,500 balance
• Each consumer paying the minimum payment due (3% of balance)

Consumer 1 would pay back approximately $3,000 over the course of eight and a half years. Consumer 2, however, would pay back close to $9,225 over the course of 21 years. While Consumer 1 would only pay $500 in interest, Consumer 2 would pay back over $6,725 in interest charges on top of the principal. That is a high price to pay.

Since damaged credit will cost you more in the long run, it is a good idea to try to keep your credit rating the best it can be. If you want to have good credit, then you need to use it wisely. Pay the balances in full every month, or if you are unable to, pay substantially more than the minimum due. At the very least be sure to pay the minimum due and always pay your bills on time. Late payments could cause late fees, raised interest rates and can hinder your chances of receiving future financing.

Another thing that can affect your ability to qualify for financing is the creditor you have accounts with. Lenders know who is a “D” lender and who is an “A” lender. If you have accounts with “D” lenders, not only are you paying astronomical interest rates, you may also be compromising your ability to qualify for better types of financing with lower rates. It’s best to maintain accounts with “A” lenders (with lower interest rates) and avoid “C” & “D” lenders (with high interest rates).

Start treating money like money, and credit like credit. Use funds that you have before you start using credit. And when you need to apply for credit, or want to establish good credit, be sure to do it wisely. Apply for credit cards with no or only a small annual fee and a low interest rate. Be wary of low introductory rates, for they usually rise considerably after the first three to six months. Following these tips can help you keep your credit in good shape and pave the road for a better tomorrow.

In their efforts to evaluate consumer credit worthiness, creditors depend on credit reporting bureaus to supply reports that provide more specific consumer information. Most creditors have automated systems that allow them direct access to credit reports from the different credit bureaus. Credit bureaus contain personal information, account history information, legal information, and information about inquiries.

Some lending institutions use more than one type of credit report because they are required to as a measure of meeting lending requirements. Others use multiple sources to ensure that they are getting a more comprehensive background on a consumer’s credit history. When a consumer completes a credit application, many creditors submit the personal information that is on the credit application to credit bureaus. This is how the credit bureaus compile personal information such as a consumer’s name, employment information, address, social security number, marital status, and telephone number. By using a credit report, the creditors will be able to cross-reference the information that the consumer provides on their application with the information that the credit bureau accumulated through other credit applications. Many credit institutions hire companies that research and verify that the information on a consumer’s credit application is accurate.

If you have an account with a creditor that reports to a credit bureau, your credit report will reflect a payment and account history. The information that a credit bureau reports regarding a consumer’s history on a credit account is referred to as a “tradeline.” On your credit report, there should be a “tradeline” for every creditor that reports account information to the credit bureau that is providing the report. Following is a summary of the information that is normally included in a “tradeline” on a consumers credit report:

1. Name of the creditor
2. Account number (usually incomplete of coded for security purposes)
3. Type of account (installment loan or revolving)
4. Balance owed
5. Summarized payment history
6. Date the account was opened
7. Credit limit
8. Co-signers on the account
9. Date information was last reported to the bureau

In addition to the information that is normally reported, a “tradeline” may indicate the following:

1. If the account has been included in a bankruptcy proceeding
2. If there has been a repossession of collateral
3. If an account has been charged off
4. If an account has been turned over to collections

Not all credit institutions report to credit bureaus, but most of them do. Most credit bureaus report payment history in 30-day payment intervals because 30-day periods are reflective of monthly billing cycles and payment installments. Policies vary amongst creditors with regard to the threshold at which they report delinquency to the credit bureau. Some creditors do not report delinquency until the consumer’s account reaches 60 days past due, while others report delinquency at 30 days past due. Some creditors do not report any account history to the credit bureau unless there is delinquency on the account.

The “historical method” of reporting delinquency on your credit report will reflect the number of times that you fell more than 30, 60, 90, and 120 days behind on your payment obligations. Other credit reports utilize a rating system that assigns a “status” for each 30-day range of delinquency. This method is referred to as the “simple method of payment.” An R-1 rating indicates an account that was current or paid “as agreed.” An R-2 indicates that a consumer paid 30 days or more after the due date but less than 60 days after the due date. An R-3 indicates that the bill was paid 60 or more days after the due date but less than 90 days past due. An R-4 indicates that the consumer paid 90 or more days past due but less than 120 days. R-5 indicates that a consumer paid 120 or more days past their due date. R-7 usually means that a creditor repossessed collateral on the account and R-8 reflects that the account was turned over to collections. R-9 can be used to reflect many different statuses on an account. It may be used to reflect that a debt was discharged in bankruptcy, repossessed, foreclosed upon, or in collections.

Credit reports often include a section that provides information that is considered public record such as tax liens, judgments, and arrests and convictions. Credit reports also give records of inquiries. Inquiries are records that reflect requests made by creditors to a credit bureau for a consumers credit report. Inquiries indicate the name of the creditor that requested the report and the date on which the report was requested.

Following are factors that are of particular interest to lenders:

• Does the applicant have a stable job? How many years have they been at their place of employment? Do they have a responsible job title?
• Does the applicant have a stable style of living? Have they been at their place of residence for five years or more? Do they own or rent their home?
• Does the applicant exhibit stability with their finances? Do they have a checking and savings account? Do they have many recent inquiries?
• Does the applicant have a good payment history on existing and previous lines of credit? Do they have a past credit history free of judgements, bankruptcies, charged off accounts, or other signs of financial mismanagement?
• Does the applicant have a favorable debt to income ratio? (Debt to income ratio is a comparison of your outstanding indebtedness the income that you have to support debt repayment) Does it appear as though they are overextended on credit?

Credit Scoring

Creditors often rely on credit scores to help them determine the risk of lending to consumers. The information on a consumers credit file may be used to compile a score that will be used to determine if a consumer is granted a loan or line of credit. If a decision is made to grant a line of credit to a consumer, the credit score may be used to determine the interest rate that will be applied to the loan or line of credit. Generally speaking, the riskier it is to lend to a consumer, the lower the chances are that the consumer will be approved for the line of credit and the higher the interest rate at which the consumer will be required to repay the debt at if they are approved.

Many lenders have “in house” scoring systems but they also rely on scoring models that are provided by credit reporting bureaus. Different credit bureaus use different credit scoring models, but the standards of determining a consumers credit worthiness are consistent from model to model and they are based on the Fair Isaac Company’s scoring criteria. The scoring system that is used may be termed a “Beacon,” “Empirica,” or a “FICO” score depending on what credit bureau is supplying the score. Some lenders rely upon “merged” credit reports that provide a compilation of consumer account and credit scoring information from more than one reporting bureau.

A bankruptcy filing is a black mark on your credit history. This can make it difficult to obtain loans, mortgages, and credit cards. Both a Chapter 7 and a Chapter 13 bankruptcy will appear on your credit report for 10 years. During this time, you may be subject to several financial hardships:

1. Secured loans may be more expensive to acquire. Only a handful of lenders may approve you for mortgage and car loans. Acquiring a loan or mortgage may require an initial down payment of as much as 50%, and you may need to accept interest rates significantly higher than those offered to people with clean credit histories.
2. Unsecured loans may be impossible to acquire. Credit card companies typically reject applicants with bankruptcies on their credit histories. You may only be able to obtain a secured credit card, which requires a security deposit typically equal to the amount of credit initially granted. Fees for these cards are generally higher than for unsecured cards, and issuers may charge an application fee.
3. Not all retirement account assets are protected. Qualified retirement accounts, such as 401ks, are protected in all bankruptcy filings. And, up to $1 million in an individual retirement account is protected. Federal law requires that only those assets needed to support a filer and dependents are exempted, so you may only be able to keep a portion of an IRA account.
4. New legislation makes filing for bankruptcy more difficult. The Bankruptcy Reform Act of 2005 prohibits some people from filing for Chapter 7 bankruptcy; adds to the list of debts that people cannot get rid of in bankruptcy; makes it harder for people to come up with manageable repayment plans; and limits the protection from collection agencies for those who file for bankruptcy. In addition, anyone filing for Chapter 7 or Chapter 13 must undergo credit counseling at their expense six months prior to filing for bankruptcy and will also be required to take a financial-management course after filing.

Any individual contemplating bankruptcy due to unmanageable debt problems should seriously consider alternatives before moving forward with a Chapter 7 or Chapter 13 filing. With many qualified debt settlement  professionals available to help individuals settle their outstanding debt, many people find that there may be legitimate alternatives to bankruptcy with potentially fewer long-term repercussions.

This article is for informational and educational purposes only.  It is not intended to provide legal, tax or financial analysis.  Please consult your attorney, accountant or tax advisor if you have legal, financial planning, or tax related questions.

Excellent article this morning in the Washington Post about how the credit card companies’ practices are driving down credit scores for many people.

Credit Score Shell Game

As High Scores Vanish, Borrowers’ Luck Runs Out

Read the full article here.

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We have often provided tips and insights into how to better manage and rebuild your credit file – something that we all should take a bona fide interest in. Since seeing is believing, we felt compelled to provide some examples of how your credit score could actually affect you.

By examining the charts below, you can see that even relatively small shifts in your credit score can make a big difference in the rates you pay. And, what seems like a small difference in monthly payments can add up over time.

To put these savings into perspective, let’s say you invested $100 per month of money saved into a simple mutual fund that earned on average 10 percent per year. Well, after 40 years, your savings would be valued at somewhere around $559,500. You get the idea.

So remember, be diligent in keeping your credit score healthy – now and well into the future – because as you can see, credit scores really do matter.