April is Financial Literacy month. Let’s continue this month with going from some must-dos to understanding the basics of credit, why it’s important, and the 5C’s to watch out for.
The Basics……
When applying for a loan, a credit card, or a mortgage, the lender will want to know if you can pay back the money. Learning what lenders are looking for will improve your chances of getting approved when you apply.
For starters, lenders will look at your creditworthiness, which is how you’ve been managing debt, and if you have the bandwidth to successfully take on more debt.
Another hidden little secret about creditworthiness is that it’s based on faith. Faith in you to manage your debts, faith in you to timely pay back a loan, and faith in your ability to successfully use debt.
As I discussed here, successfully using credit and other people’s money is one of the keys to financial success and is a major lifeline in today’s world.
While I love living on a cash budget (because cash is king! 😊), the sad reality is that your ability to successfully use credit can mean the difference between financial ruin and financial independence.
Why Good Credit Is Important
With a good score, a person will qualify for the lowest interest rates on credit cards, car loans, mortgages, etc. This credit buffer comes in especially handy if an emergency arises before a 6-month emergency fund can be saved up.
Good credit is necessary if a person plans to borrow money for major purchases such as a car, a home, or taking out additional personal loans. A higher credit score can mean better interest rates and loan terms. Many card issuers reserve the best rewards and best interest rates for customers with great credit.
Lenders are not the only ones concerned with credit scores. For example, it is typical for a landlord to check a potential tenant’s credit rating to determine not only how large of a security deposit to require but also to verify that the tenant has a good probability of paying the rent on time. Insurance companies use credit scores as a factor in charging insurance rates. Even employers have been known to check credit scores as a factor in determining hiring decisions. Practically speaking, a person’s entire adult life revolves around their credit score.
This is why it is so important to build up a good credit rating over time. It could mean the difference between financial success and living in your parent’s basement until you’re 50! 😊
Understanding The 5C’s of Credit
Lenders use the 5C’s to evaluate credit risk and assess creditworthiness. The 5C’s also help lenders determine how much an applicant can borrow and the interest rate to pay back the loan.
Let’s dig into them and explore further…….
Character
Character refers to your credit history or how you’ve managed debt in the past. Your credit history starts to develop when first opening a credit card and taking out your 1st personal loan.
The lenders then reports your account history to credit bureaus which are captured in documents called credit reports. The information in credit reports is used to calculate credit scores.
Credit scores work on a scale from approximately 500 to 800. When a person interested in your capability to handle additional debt looks up your credit score, the higher the number the more credit worthy you are and the better your “credit character”.
Lenders look at your payment history and how much you have borrowed to determine if you qualify for a loan or credit. They also check for any foreclosures, bankruptcies, and any late/missed payments on your credit history.
To develop a strong credit history, always make payments on time and try to keep your credit utilization (how much of your credit you use) low.
Capacity
Your capacity refers to your ability to repay loans. Lenders check your capacity by looking at how much debt you have and comparing it to how much income you earn. This is known as your debt-to-income ratio (DTI for short).
Debt-to-income ratio is calculated by adding up your monthly debt payments, dividing that by your pre-tax income, and multiplying that number by 100.
A low DTI ratio signifies that you are less risk to the lender and more likely to repay back your loan in a timely manner. A rule of thumb is to keep your DTI ratio at less than 36% for homeowners and 20% for renters.
Here is an example: If your student loan payment is $200 a month, your car loan payment is $300 a month, and your mortgage is $1,200 a month then your total monthly debt is $1,700 a month.
If your monthly gross income is $5,100, here is how to calculate your DTI ratio. 1,700 divided by 5,100 = 0.33. Next, multiply 0.33 by 100 to get your DTI as a percentage. In this case it is 33%.
The lesson here is to keep your expenses low and only apply for the credit that you need. A low DTI ratio shows lenders you have the capacity to take on an additional loan payment.
Capital
When people talk about “capital” they are referring to all your assets and investments that you are willing to put toward a loan. Capital provides additional security and is used to ensure that in the event you default on your loan, the bank can sell your assets to recoup their losses.
Capital to put towards a loan could be anything from savings to real estate to ownership in a business to a whole life policy. Typically, your income is often the primary source for paying off loans. If anything unexpected happens that affects your ability to pay off the loan (i.e., job loss), your capital may be what is used to pay off the loans.
For buying a house, a down payment can be used as capital for the mortgage. Down payment size can affect both the duration (term) of the loan and loan interest rates. For example, putting 20% (or more) as a down payment on a house can help the borrower avoid paying for private mortgage insurance (PMI). PMI acts as insurance against you defaulting on the loan if putting down less than 20% of the home value.
Collateral
Collateral is anything you can provide as security for taking out a secured loan or secured credit card. If you cannot make payments, the lender or credit card issuer can take your collateral. Providing collateral can also help you secure a loan or credit card if you don’t qualify based on your current creditworthiness.
The asset you provide as collateral depends on the type of loan taken out. For example, for an auto loan the car being purchased acts as collateral. For a secured credit card, you’d put down a cash deposit to open the account and is used as collateral.
If you follow the terms of the loan and make timely payments until the loan is paid off, you get to keep your collateral.
Conditions
Conditions include other information that helps determine whether you qualify for credit and terms of service. For example, lenders look at the length of time an applicant has been employed at their current job and the projection of their future job stability.
Conditions can also refer to how a borrower intends to use the money. A lender may be more willing to lend money for a specific purpose as opposed to a personal loan that can be used for anything.
Consider a borrower who applies for a home improvement loan. A lender is more likely to loan money for home improvements because the end result is that the home goes up in value and further reinforces the borrower’s ability to pay back the loan.
Additionally, lender may consider conditions that are outside of the borrower’s control such as industry trends, economic conditions, and legislative changes. These conditions allow lenders to evaluate their risk.
Bonus “C”
Some people also consider credit score one of the “C’s”. As we talked about above, your credit score goes along way towards determining your creditworthiness. IMO, if you take care of the other 5C’s, your credit score will take care of itself.
Bottom Line
The 5C’s of credit helps lenders to evaluate risk and ascertain a borrower’s creditworthiness. These factors also help lenders determine how much an applicant can borrow, the loan terms, and the interest rate to charge.
Don’t discount your credit score either. Take care of the 5C’s and the credit score will take care of you.
Good credit is necessary if a person plans to borrow money for major purchases. A higher credit score can mean better interest rates and loan terms on several types of loans and credit including credit cards. Many card issuers reserve the best rewards and rates for customers with great credit and a great credit score.
Lenders are not the only ones concerned with credit scores. Landlords, prospective employers, and even insurance companies use your credit score to determine your worthiness to rent an apartment, apply for a job, and even purchase insurance.
This is why it is so important to build up a good credit rating over time. It could mean the difference between financial success and living in squalor…… food for thought.
Live The Life You Love, Want, And Deserve!