Financial Literacy - Unit 3

Credit

The term has many meanings: an accounting entry, a legal agreement, creditworthiness. It involves borrowing money, or the ability to receive goods and services today with the promise to pay it back in the future. It is not really a promise but a legal obligation.

Credit Responsibilities

Credit can be an effective tool if managed responsibly. Borrowing money means you are spending future income before you have received it. When we use credit we jeopardize our future discretionary income. If credit is not managed properly it can lead to stress and have a negative effect on your well-being and quality of life.

Discretionary Income

The money leftover after ALL living expenses have been paid. Examples: rent, mortgage, utility bills, phone, cable, streaming services, food, insurance, loan payments, etc.

Sources of Credit

They can vary from family and friends to more traditional sources such as: insurance companies, banks (mortgages/auto loans/personal loans), merchants (retail stores), and the government (education, housing, small business loans)

Net Interest Margins

Known as the ‘spread’ which is how banks make money. The spread is the difference between deposit rates and lending rates.

10 Year Treasury Significance

Benchmark used by banks to determine mortgage rates

Cost of Credit

Expressed/measured in terms of the interest rate. Credit cards charge compound interest (daily interest) which means the amount you owe can add up rapidly.

Benefits of Not Using Credit

Spending in cash (including debit card’s which pull money directly from a bank account) is best because there is no legal contract, no fees/penalties, we are not being charged high interest rates, and we are NOT jeopardizing future discretionary income.

Positive Credit Behaviors

Need to be very intentional/purposeful when we use credit. Seek credit sparingly (no need for more than ONE credit card). Pay bills on time and in full (must keep utilization rate low). Monitor credit usage. Review credit report for accuracy.

Negative Credit Behaviors

Behaviors to be avoided. Missing payments will drop credit score rapidly (shows you can’t be trusted). Late payments (you can’t handle the responsibility). Having too much of one type of credit (no diversification) such as credit cards. Chasing rewards such as points, airline miles, or cash back from spending is dangerous and not worth the benefits.

Revolving (Open Ended) Credit

Examples: Credit Cards/Credit Lines from a Bank. It is unsecured credit. There is no collateral associated with it. It is established in advance (no need to re-apply). Variable Interest Rate and variable payments (depends on the amount charged and how they decide to repay).

Installment (Closed Ended) Credit

Examples: Auto loans/Mortgages/Student loans. These loans are secured loans. Loans based on the purchase of an asset like a car or house. Loans are based on a fixed rate of interest that does not change over the life of the loan. Loans are repaid in equal amounts over a specific period of time. Car loans may last a few years while a mortgage loan can last up to 30 years. The payment amount does NOT change each month until the loan is repaid in full.

Alternative Credit

May combine elements of closed-end or open-end credit. It is a type of last resort (not a good option) credit. These sources of credit charge higher rates than conventional credit, lots of fees and should NOT be considered. These lenders do not judge applicants based on a credit history. At most they may do a soft credit check to see if your account is in good standing. These sources of credit are generally short-term loans at high rates of interest. They may judge applicants on proof of income or some other metric.

Alternative Credit Examples

Payday Loan, Rent to Own, Title Loan, Pawn Loan, Refund Anticipation Loan, Credit Cycles

Payday Loan

Short term loan secured by the borrowers written check or authorization for automatic withdrawal from borrower’s bank account

Rent to Own

Tangible items are leased (furniture/appliances) until the terms of the loan are satisfied. Once loan is paid off the items will be owned.

Title Loan

Borrower gives title for automobile to lender in exchange for a loan. If terms of loan not satisfied the lender keeps the title to the automobile.

Pawn Loan

Borrower gives personal property to the lender to secure a loan. If loan terms not meant the lender keeps the property.

Refund Anticipation Loan

Short-term cash advance secured by a taxpayers expected tax refund.

Credit Cycles

It is aligned with the business cycle of rising and falling economic activity. When the economy is expanding (GDP is rising) more credit is offered and when the economy is contracting (slowing GDP) credit conditions are tightened making it more difficult to acquire credit. Gross Domestic Product (GDP) is our best measure of economic activity and as you would imagine they are aligned with cycles of rising and falling economic activity.

What is a Credit Card

A revolving line of credit established in advance. They are issued by banks, retail stores, and merchants. They are useful tools for new borrowers for establishing a credit history if they are used responsibly but can be very damaging if they are abused.

Credit Card Benefits

Can be a convenient payment tool - need to carry cash, useful in emergencies, they offer consumers fraud protection, they can be a good tool for establishing credit, and some consumers like the rewards program – earn free miles, discounts on hotels/merchandise, or cash back but ALL require the consumer to spend money in order for them to receive benefits

Credit Card Drawbacks

They charge daily compound interest. Teaser rates can be misleading and can change any time the consumer makes a mistake. This debt is the most expensive debt you will EVER encounter. The companies charge high rates for credit, high fees, and numerous penalties for bad behavior. They are easy to abuse, they can harm your credit, and lead to a cycle of debt which can negatively impact your health/well-being. When we use this, we are jeopardizing our future discretionary income.

Pre-Approved Application

Credit card companies look for new consumers by sending these out in the mail. This means the company has performed a soft credit check. They don’t actually pull your credit report but they use a software that tells if your account is up to date without any outstanding debts. If you have received this type of offer it means you have passed the first step in the screening process.

Deadbeat

A derogatory term that credit card companies call users who pay off credit card balances in full each month. Credit card companies do not make interest/fees off deadbeats. They keep credit card utilization rate low so they do not get charged ridiculously high rates

Positive Credit Card Behaviors

Need to be intentional when we use a credit card. Seek credit sparingly. It is important to have a mixture of credit. Good behavior-small purchases that are paid in full when the bill comes. New credit card users should NEVER leave a balance on the card. If a consumer utilizes credit by not paying the balance in full it will lower your credit score.

Schumer Box

Credit card issuers are required to disclose the terms and fees of each credit card offer in an easy to read box. Consumers can review this to better understand the cost of the credit so they can make easy comparisons when shopping for credit.

Credit Cards vs Debit Cards

A credit card charges interest and fees when a consumer utilizes credit. Debit Cards are connected to checking accounts and are better options for everyday purchases. When a consumer spends on a debit card they are using their own money. Credit Cards are lines of credit and if the purchases are not paid in full the consumer will have high interest expenses.

Credit Card Annual Percentage Rate (APR)

Credit cards charge borrowers compound interest (interest-on-interest) on the balances that cardholders carry. Credit card companies can change this (interest rate) at any time for poor behavior which we call a Penalty. Credit card companies charge different ones of these (interest rates) for different activities like: balance transfers, cash advances, introductory or teaser, etc.

Borrower

Someone who receives something today with a promise to pay it back in the future

Lender

A person or company who makes funds available to borrow

Credit History

A record of the borrowers past lending and credit-related activities. It tells lenders how trustworthy you are as a borrower.

Credit Report

A record/statement/report of a person’s use of credit. It reflects information about your current credit condition.

Credit Score

A three-digit number that reflects the likelihood a consumer will repay their debts. It is a measure of the consumers trustworthiness. Each consumer will have numerous credit scores. Companies evaluate statistical characteristics found in a consumer’s credit report when evaluating things like: payment patterns, amount of debt, and type of debt, etc. They do not appear on credit reports.

Soft Credit Check

You have been pre-screened for a credit card offer. Credit Card Company performs this to see if you are in good standing and ‘current’ and do not have any late/outstanding or missed payments before they send out pre-approved credit offers. This type of inquiry has NO impact on your credit score. These inquiries typically happen as part of a background check by employers or landlords before any offers are made.

Hard Credit Check

This is a formal credit check that involves pulling a consumer credit report and history. These will negatively impact a credit score. Multiple over a short period of time are problematic and will tell lenders you are seeking too much credit. Credit should be sought out sparingly.

Fixing Credit

it is important to monitor your credit history. Low credit scores are low because consumers have bad habits. It is an easy process:make payments on time and begin to reduce the total amount of debt. High scores are high because consumers practice good habits. It is difficult to raise high scores but very easy to damage a high credit score. One missed payment can hurt a high credit score more than the same missed payment for a low credit score.

Major Credit Reporting Agencies (CRA)

Experian, Equifax and Trans Union

Credit Report Personal Information

Name, address, social security number, telephone number, date of birth, employment history

Public Record Information on a Credit Report

Bankruptcy, foreclosure, tax liens, collection agency reports on items that have not been paid back

Negative Credit Report Information

Hard credit checks which are the result of applying for credit, seeking credit too often, failure to pay any debt by the due date, making late payments, having too much similar credit – ex: too many credit cards.

Things that have no Effect on Credit

You checking your own credit (one free credit check per year), soft inquiries/background checks, receiving a pre-approved credit card offer in the mail, employer/landlord background check.

Shopping for Credit

CRA’s are aware of this. If multiple credit checks come in for the same type of credit within a 14-day period it will have no impact on your credit score.

What is not on Credit Report

Your credit score does not appear, medical information about you, race/gender, religion/ethnicity, buying habits, and criminal history

How can Consumers Improve Their Credit

Some activities take a long time to remove from a report. TIME is the only way to clean-up a credit report. Some CRA’s retain historical information on a credit report for up to 10 years bankruptcies/foreclosures.

Positive Credit Activities

Pay bills on time, pay bills in full, apply for credit sparingly, have a diverse mix of credit, check credit report annually

Fair Issac Corporation (FICO)

Most common credit scoring model. It is a data analytics company founded by Bill Fair and Earl Isaac in 1956. They created a proprietary model considered the most reliable scoring model. By 1989 banks began to use These scoring models to evaluate a consumer’s trustworthiness. These scores range from 300 to 850. There are hundreds of scoring models in use today.

FICO 5

FIVE components that make up a FICO credit score: 35% Payment History, 30% Debt Amount, 15% Length of Credit History, 10% New Credit, 10% Credit Mix

Misconception 1

FICO is the one, true credit score:

FICO is the most common but there are dozens of companies producing credit score models – Vantage Score, Credit Karma, Trans Risk, Credit Xpert Credit Score, etc

Misconception 2

Checking Your Score is Bad for your Credit:

Hard Inquiries knock off a few points when your credit is checked on a lending decision. Soft inquiries do not effect your credit and are part of a background check

Misconception 3

My Credit Score Affects Future Job Opportunities:

Potential employers don’t look at your credit score, they actually pull your credit report to see how well a candidate has managed their own credit. They must ask for your permission. Credit scores are not on a credit report.

Misconception 4

It takes forever for a Credit Score to Budge:

Poor credit scores are relatively easy to improve. By simply paying back debt owed it will have a significant impact on a credit score. High credit scores are difficult to move incrementally higher. Missteps are just the opposite. One missed payment will have a bigger negative effect on high credit scores than the same missed payment on a low credit score.

Misconception 5

Credit Cards Are Good for your Credit Score:

Too many credit cards is not good for a credit score. This is viewed by CRA’s negatively and indicates the borrower is in need of credit which may be a problem. They want to see a diverse mix of credit.

Misconception 6

I don’t have to worry, I already have an excellent credit score:

Consumers with high credit scores need to be diligent about maintaining their good credit. Small mistakes will impact good credit scores more negatively than the same mistake for someone with poor credit.