Understanding Credit

Credit gives you the ability to purchase larger items when you don't have the money available or that would be outside your reach otherwise, such as a home or a car. It involves borrowing money with the understanding that you will pay back what you borrowed over time – usually with interest added. Using credit also helps you build your reputation as a borrower. The more disciplined you are in repaying what you owe, the better your credit history. Good examples of credit are student loans and car loans, as well as credit cards.

Understanding Types of Credit

It's important to note that there are different types of credit, so you can be sure that you get the right type of credit for your needs. There are three main types of credit:

  • Open-end revolving credit (secured or unsecured)
  • Open-end 30-day credit
  • Closed-end credit

Open-End Revolving Credit

Open-end revolving credit comes in two types: secured and unsecured.

Open-End Revolving Credit (Unsecured)

Here you have a fixed credit limit and must pay at least the minimum amount due on your outstanding account balance each month. The minimum payment requirement is calculated as a percentage of your total balance.

The interest rates associated with open-end credit are usually higher, especially if you have a bad credit history or don't shop around for the best deal. Examples of this type of credit include credit cards like MasterCard and Visa and many retail store cards.

Open-End Revolving Credit (Secured)

This requires you to secure your credit purchases by keeping a certain amount of money in a related account or by making a deposit for a certain amount. If you do not pay your bills on time or if you go over your credit limit, the creditor uses the allocated funds to cover any gap. Often, people with bad credit or no credit history use a secured credit card until they can qualify for a traditional unsecured credit card.

Open-End 30 Day Credit

Open-end 30-day credit usually comes with a high credit limit, but you must pay your outstanding account balance in-full at the end of every month.

An American Express card is the most common example of open-end, 30-day credit.

Closed-End Credit

Closed-end credit is what you get when you are approved for a mortgage, finance the purchase of a car, obtain a student loan, or some similar purchase.

Using Credit Wisely

You should NEVER use more than 15% of your income on outstanding debt payments!

So how much credit can you afford to have? Let's say you earn $500 a month after taxes; your yearly net income is $6,000 (12x$500). At this level, your outstanding debt should never be more than $900 ($6,000 x 15%).

Your goal should always be to borrow less than 15% of your yearly net income.

Tips to follow:

  • Follow your agreements. Pay your credit cards off according to the terms provided in your agreements.
  • Pay online. Paying your credit cards online or over the phone can help you incurring late fees. Being late will damage your credit score. In addition, just one late payment could trigger a steep increase in your interest rates, depending on the terms of your agreement.
  • Keep your balances low. Don't run up high balances on your credit cards. If possible, when you make a major credit card purchase, do not charge anything more on that card until you pay off the balance. If you have to maintain a balance on a credit card, always pay more than the minimum amount required to eliminate the debt faster.
  • Cancel unnecessary cards. Cancel any retail charge cards you may have and pay off their balances. Store cards tend to have high interest and harsh terms.
  • Read all important information. Look through the inserts that come with your credit card statements. Most inserts will probably be solicitations, but some could notify you of changes in your terms. These changes are usually good for the card issuer and not for you. Other inserts may allow you to opt-out of having your credit card company share your personal information with other companies, which will decrease junk mail, spam and call solicitation annoyances.
  • Don't skip payments. If you can, take advantage of skip payment offers. You may be charged interest on your outstanding card balance for the month you skip making a payment.
  • Don't go over your credit limit. Exceeding that limit or getting close to maxing out your credit cards will damage your credit history and lower your credit score.
  • Minimize your use of cash advances. These are generally an expensive source funds, since the interest rate applied is usually considerably higher than your interest on purchases.
  • Don't buy credit card insurance. This pays your credit card debt if you become disabled or deceased, but it tends to be overpriced. It mainly serves to generate big profits for card issuers.

Things to Consider When Using Credit

  • You shouldn't have a lot of outstanding loans at once, especially loans that you have secured using your home as collateral (like a second mortgage or home equity loan). If you can't pay those loans, you could lose your home.
  • Experts agree you should not spend more than 10% of your net (take home) income on debt, not including your mortgage, car loan, and any home equity loans. So, if your take-home pay is $2,000 per month, then you should not be spending more than $200/month on your credit cards and other debts.
  • No matter how much debt you are carrying, you should be able to repay everything you owe (not including your mortgage) within 12 to 18 months. If you can't meet that goal, then you have too much debt. For example, if the total balance on your credit cards is $5,000 at 18% interest and you are paying $150 per month, it will take you more than three years and 11 months to repay your debt. You should increase your monthly payments substantially to pay the debt off within 12 to 18 months.

Don't Make Matters Worse

  • Never use another credit card or take out a cash advance to pay a credit card bill.
  • Never write a check for a credit card payment if you know you do not have the funds to cover it. Not only will you have to pay bad check fees and overdraft fees, but the creditor may sue you over the bad check and you can be criminally prosecuted. A bad check can also impede your ability to open future bank accounts with your current bank or a different financial institution.
  • Don’t get a payday loan. A payday loan is a very expensive source of quick cash. Here is how a payday loan works: You write a postdated personal check payable to the payday lender, which may be a check cashing company, a finance company or some other business. The check will be for the amount you want to borrow plus a fee. The fee will either be a percentage of the check's face value or a set amount that is based on the amount of money you borrow. For example, for every $50 or $100 you borrow you pay $X amount of money to the lender.
  • Don't get an advance-fee loan. Advance-fee loans are scams, pure and simple. Firms that make these kinds of loans advertise that you will qualify for a loan regardless of the state of your finances and the condition of your credit history. However, you may have to pay a substantial amount of money just to apply for the loan and once you do, the lender may disappear, leaving you with less money and no loan. If you do get a loan from an advance-fee lender, the terms of the loan will be unattractive and generally cost significantly more than if you had borrowed from a legitimate lender. In the end, you may get you deeper in debt.
  • Don't pawn your possessions. A pawnshop loan is an expensive source of money. Not only will you have to leave the item you pawn at the pawnshop but also the pawnbroker will only lend you between 50 percent to 60 percent (or even less) of the item's resale value. You will have a couple of months to repay the loan and during this time, the pawnshop will charge you a very high rate of interest—between 10 percent and 20 percent a month—which translates to an annual interest rate of between 120 percent and 240 percent! Furthermore, if you can't afford to repay the loan, the pawnshop will keep the item you pawned and resell it.

Your Credit History

There are three national credit reporting agencies (also known as credit bureaus): Equifax, Experian, and TransUnion. One way they make money is by collecting credit information about consumers and selling it to creditors, employers, property owners, government agencies, and anyone else who is legally entitled to it according to the federal Fair Credit Reporting Act (FCRA).

This law regulates credit reporting agencies and establishes your rights regarding the information in your credit report and your dealings with credit bureaus.

Your state may have its own credit reporting law which provides you with more protections and better remedies when your rights are violated. Contact your state attorney general's office to find out if your state has such a law.

Credit reporting agencies get their information about you from a variety of sources, including your creditors and court records. If you have credit now or have had it in the past, it's likely that all three of the national credit bureaus are maintaining a credit history on you.

In addition to your credit history, your credit report also provides:

  • Personal Information: Your name, Social Security number, current and past addresses, the name of your spouse, and the name of your present employer.
  • Public Record Information: Information about any bankruptcies you may have filed over the past 10 years, unpaid tax liens on your property, court judgments against you, etc.
  • Inquiries: The names of companies who have looked at the information in your credit report. For example, your current creditors may have reviewed the information to help them decide if they should increase your credit limit or change the interest rate on your account. Other creditors may have looked at it to decide whether or not to send you a pre-approved offer of credit.

Tip: Always review your credit reports before applying for a new line of credit or a new loan. You may also wish to review your reports before a new job interview or review for a promotion, before you apply to rent property, and before you apply for a government license, security clearance or government benefit.

If you’d like to get a copy of your credit reports, you are entitled to one free copy of each credit report annually. You can get your free reports at www.annualcreditreport.com or by calling 877-322-8228.

Credit Scores

A credit score is a snapshot of a person’s credit picture that allows creditors and lenders to assess the level of credit risk of each individual. This numeric value can move up and down over time, depending on your credit history. The higher the score, the better your chances for approval on a new loan or to get a more favorable interest rate on a new line of credit.

Determining Your Credit Score:

The following five factors determine credit scores:

  • Payment history - 35%
    Timeliness of Payment: Factors in your credit history and all account payment information for credit cards, lenders and retailers. This is to measure your ability to pay your bills on time.
  • Amounts you owe - 30%
    Debt to available credit ratio: The total amount of credit you have outstanding relative to the maximum amount of credit that your creditors are willing to extend.
  • Length credit history - 15%
    This measures of the length of time your accounts have been open with creditors and lenders.
  • New credit - 10%
    This is the number of times you've applied for credit in the recent past.
  • Type of credit in use - 10%
    This evaluates the diversity of your debts, including things like credit cards, personal loans, your mortgages and car loans.

Building Your Credit

There are four basic steps to rebuilding your credit:

  1. Develop a savings habit. Saving as much as you can is important, but saving regularly is even more important. Get in the habit of regular contributions to a savings account or money market fund—whichever offers the best interest rate.
  2. Take advantage of any direct deposit programs your employer may offer. It's easier to get into the savings habit when the money is never in your checking account, and goes directly into your savings account or money market fund.
  3. Review your Equifax, Experian and TransUnion credit reports and get mistakes corrected. You do not want mistakes, errors and discrepancies on your credit reports to get in the way of building your credit. To get sample letters to help you dispute mistakes with the credit bureaus, please click here.
  4. Once you have saved between $500 and $1,000 and resolved any problems in your credit reports, apply for a MasterCard or Visa. Shop around to find the card with the best terms that you can qualify to receive. If you can't get an unsecured MasterCard or Visa, apply for a secured card.

Credit and Saving: Four Good Reasons to Save Your Money

Saving is just an important part of rebuilding your credit. Here are four quick reasons why saving is so important:

  • If you lose your job tomorrow, the money in your savings account will help you pay your bills.
  • If you have an unexpected large expense, you can use your savings to pay it rather than having to use credit.
  • When you begin the credit rebuilding process you may need money in savings in order to qualify for a secured MasterCard or Visa.
  • Creditors will feel more comfortable about extending credit to you when you have a healthy balance in your savings account.

The Fair Credit Reporting Act

The Fair Credit Reporting Act (FCRA) and its amendments give you rights when you are dealing with credit reporting agencies. You are entitled to a free copy of your Equifax, Experian and TransUnion credit reports once per year. You are also entitled to have:

  • Most negative information in your credit history removed after seven years. However, a Chapter 7 bankruptcy will be reported for 10 years, unpaid tax liens for 15 years and court judgments for 20 years.
  • A credit bureau conduct an investigation when you believe that information in your credit history is inaccurate or out-of-date. If the credit bureau confirms that the information is wrong, they are required to have the information corrected or deleted.

The credit bureau that conducted the investigation will notify employers and creditors about corrections and deletions in your credit history. (Within the previous two years for employers or the previous six months for anyone else.)

The FCRA also entitles you to:

  • Include a written statement of up to 100 words in your credit report when a credit bureaus’ investigation does not correct a problem. Your statement should explain why you believe that your credit report is wrong so creditors and others can read it when they review your credit report.
  • The right to sue a credit bureau or a business that used your credit information in a way that willfully or negligently violated your legal rights.

You are entitled to one free copy of your credit history from all three national credit bureaus every year. To obtain your free annual credit histories, go to www.annualcreditreport.com, or call toll-free, 877-322-8228.

If you want any additional copies of your credit reports in the same year that you ordered your free annual reports, contact each individual credit bureau directly by phone, mail or online.

Disclosure Department
P.O. Box 740241
Atlanta, Georgia 30374
(800) 685-1111

National Consumer Assistance Center
P.O. Box 2104
Allen, Texas 75013
(888) 397-3742

Consumer Disclosure Center
P.O. Box 1000
Chester, Pennsylvania 19002
(800) 888-4213

Posted in: Credit and Debt