Credit in its most basic form allows you to receive money or goods today, while paying them back at some later date. A creditor provides the credit and determines whether a borrower is financially stable enough to borrow, usually by analyzing a borrower’s credit report. And of course, they’ll usually charge an interest rate on the borrowed amount until the balance of the loan has been paid off. If a borrower purchases something on credit, they’ve essentially entered into a loan agreement with their creditor. This agreement is legally binding, and the borrowed amount must be paid back according to the loan terms of the creditor, which includes the interest rate and monthly payment amount. If payments are not made in time to the creditor in the amounts originally agreed upon, a borrower will default on their loan which can lead to serious damage to their credit. But if loans are paid on time, and in the amounts originally agreed upon with the creditor, the borrower’s credit will improve as their payment history becomes a type of proof of a borrower’s creditworthiness.
Most have, by their early adult life, become a borrower and are familiar with this basic framework. Borrowers must have good credit for a creditor to feel comfortable giving a loan to them. But how is a borrowers’ creditworthiness calculated, and what can a borrower do to get better terms from a creditor?
When a financial account is opened, a firm will typically query one of the three largest credit reporting agencies, Equifax, Experian, or TransUnion, for a credit report on the person trying to open the account. These reports can differ in their assessment of a borrower’s credit risks as each reporting agency has their own methodology when producing their credit reports. But all credit reports will contain the same basic details like personal information and public records like bankruptcies. A credit report will also show credit limits, account balances, and the history and length a particular account has been opened with a creditor.
If account balances are too close to a credit limit, this may look poorly to a creditor. And if an account hasn’t been opened long or if multiple credit accounts are opened at the same time, this may also reflect negatively on a borrower. A creditor wants to see long histories of repayment, balances that are not close to their credit limits, and few new recent credit accounts created. Multiple new credit accounts may indicate financial difficulties for a borrower. If a borrower does have credit accounts that have been paid without issue for years and has low balances when compared to their total available credit, this can look very positive to a credit reporting agency.
It is also important to note that one or more of the reporting agencies may have incorrect data within their credit reports, so it’s important for a borrower to become familiar with the credit reports being produced on their behalf. Every year a borrower can request a free credit report from each of the three reporting agencies. Before a large purchase a borrower should request one or more credit reports to be prepared for any questions a creditor may have. If there are missed payments, defaults, or if credit history is too brief, a creditor may deny an application for credit.
A credit report’s information is summarized in a numerical credit score produced by each of the three credit reporting agencies. This credit score can fall anywhere between 300-850, with higher scores indicating greater creditworthiness. Borrowers with credit scores over 700 will largely benefit from lower interest rates and better terms from lenders. But borrowers with credit scores below 500 may be denied credit as they may be deemed too great a risk. It’s vital for a borrower to keep their credit score as high as possible, so that lenders can offer them lower rates.
Types of Credit
The average American borrower most likely has access to three types of credit: credit cards, personal loans, and mortgages. Each type is vastly different in terms of interest rates and terms for the borrowers, so let’s go over each in detail, weighing their pros and cons.
There are over 365 million credit card accounts in the U.S. and each year that number grows. Many Americans receive unsolicited credit card offers almost every day. It’s important to realize that many of these credit card offers are unsuitable for most people as their interest rates and annual fees are prohibitively high, some with rates as high as 25% (or higher!). A borrower should also consider the amount of total credit that can be withdrawn in cash, as many cards have restrictions on the amount of cash that can be taken out. Take the time to research credit card terms and approach any offer you receive with a high degree of skepticism. Also, you shouldn’t always assume a credit card offered by your bank will have the most attractive terms.
If your credit score is relatively high and you simply want a low-interest card, you might avoid rewards cards that offer promotions like bonus miles or cash-back on purchases. But if you travel a lot, rewards cards that provide bonus miles may make more sense. There are usually many cards that offer rewards or low rates with no annual fee, so make sure to take fees into account when considering a credit card. Some cards do have annual fees, and yet still may be worth it according to the needs of the borrower. For example, an airline may offer a credit card that charges over $100 as an annual fee but has very favorable bonus mile terms. If you are a frequent traveler, you may save more money using the credit card’s rewards than the annual fee, so in this case an annual fee is reasonable.
There is no one feature of a credit card that is perfect for everyone, so take the time to consider what’s most important to you in a card. Most Americans have more than one credit card, so if there are rewards gained with additional cards, it could be reasonable to have more than one. Always keep in mind though, that the larger debts you have relative to your credit limits, the worse your credit score will be.
Personal loans have much in common with credit cards, but there are a few important differences. A personal loan is not considered a revolving line of credit like a credit card. In other words, a borrower cannot access the paid-off balance of a personal loan, like they can with a credit card. For example, a credit card borrower that has a balance of $1000 and a limit of $10,000 can once again use all $10,000 worth of credit once their balance has been paid off. If the borrower has a $10,000 personal loan with a balance of $1,000, once that $1000 is paid off, the loan is terminated; no new funds can be accessed under that loan agreement. Many see this feature of personal loans as a drawback, but it also helps a borrower avoid a never-ending cycle of debt. Most personal loans have a length of just 3-5 years, and their corresponding minimum payments can be much higher than credit cards. Having a definitive end to the loan can be very helpful, especially if paying only minimums. Credit card minimums are so low, that debts can take decades to pay off if only paying the minimum amount each month. Once again, it’s up to the individual borrower to decide if a credit card or personal loan works best for their credit needs.
Mortgage debt is used for the purchase of a home and is often called “good debt.” It’s called good debt for several reasons. First, purchasing a home is a tried-and-true method of growing wealth, since each mortgage payments gives a borrower more partial ownership of their home. And a home will hopefully appreciate over the life of a mortgage. Paying rent, on the other hand, confers no ownership to the renter. Second, you can live in your home, and not in the purchases you make with credit cards or personal loans. Finally, interest rates on mortgages are often much lower than rates on personal loans or credit cards. Since the home itself is collateral for a mortgage, home lenders can offer very low rates. However, creditworthiness is still of great importance to home lenders. A low credit score could add many percentage points to borrowing costs, while good credit may reduce the interest rate on a mortgage considerably. One drawback of mortgages though, are their long terms. 30-year mortgages are the most popular funding vehicle for housing, and legally bind the borrower to the terms until the house is sold or the mortgage is paid off. Another drawback is that during real estate downturns, a borrower may find that they owe more on their mortgage than their home is worth.
Even considering these drawbacks, mortgage debt is by far the most beneficial. When taking on a mortgage, credit scores often rise and a pathway to home ownership is set. Personal loan and credit card debt rarely give any benefits to the borrower aside from immediate credit and rewards that may or may not be useful. Interest rates on mortgage debt are also far lower than rates on personal loans and credit cards. When choosing your creditor and the type of credit you need, keep this is mind. And always ensure payments are made on time and in full each month to all your creditors, so that your credit score remains high, and your interest rates remain as low as possible.