What is Credit?

by Brandon Young

The "credit crunch" seems to be the only thing people are talking about these days.  Headlines like those that "the banks are not lending" and "credit is frozen" are being tossed about like hand grenades ready to explode in financial portfolios.  Families cannot get loans to buy cars or houses, all the while watching their credit limits shrink and their interest rates grow.  Politicians and pundits alike are screaming about what needs to be done to avoid the "economic meltdown" and get credit flowing.  It would seem that, to really understand what is actually happening, it is necessary to take a step back and ask some questions.  Let's start with a good working knowledge of what credit is and how it works.  This article will serve as a primer on credit, to start making sense of the worldwide panic that seems to pervade the news.

First, what exactly is credit?  Credit is buying or borrowing an item now and paying for it later.  We use credit to go Christmas shopping for our families, or to purchase large ticket items like cars and houses.  In essence, credit is used to buy things when one does not have enough financial resources at the time to pay for it.  Where most people get into trouble is the part about paying for it later.

In the financial world, there are three different kinds of credit: revolving credit, installment credit, and alternative credit (non-installment credit):

Department store charge cards (like JCPenny, Sears and Macy's) and VISA, MasterCard and American Express are examples of revolving credit.  There is a limit on how much money you can spend on a revolving credit account.  As long as the credit limit is not exceeded, there will not be a problem.  If the credit limit is exceeded, the cardholder is often charged exorbitant fees and has their interest rate increased.  For example, a card with a credit limit of $1000 could easily absorb a $200 purchase.  However, a $5000 purchase would be over the credit limit, and the purchase would be denied.  NOTE: with some high limit cards such as VISA Signature or VISA Platinum, it is possible to exceed your credit limit and purchase items that you ordinarily cannot afford; significant penalties and fees would apply.

Installment credit is usually for very expensive purchases.  Car loans, personal loans, student loans, and mortgages are examples of installment credit.  These loans also tend to be long-term and vary from five to thirty years.  Because the loans are for large amounts of money and take a long time to repay, payments are spread out with installments paid back over time.  

Alternative credit, or non-installment credit, includes phone, cable, gas, and electric bills.  Bills are paid at the end of the month after services have already been received.  These bills are not listed on a credit report, but do provide a record of whether or not bills have been paid on time. 

To build and maintain a positive credit score, which is really just a measure of your reputation for paying back borrowed money, it is imperative to pay bills on time.  Not just some bills or even just the credit card bill.  It is important to pay all bills on time every month.  Every bill will affect your credit score.  Pay on time, and your credit score will remain high, pay late and your credit score goes down.  Bills that can affect your credit score include rent, phone, cable, department store accounts, student loans, car notes, and other loan payments.

A credit score is an artificially generated number used by creditors to represents creditworthiness of a borrower, and to judge the likelihood that an individual will pay the debt they accrue. The credit score is based on a statistical breakdown of the borrower’s credit report. This information is gathered from the three major American credit bureaus— Equifax, Experian, and TransUnion.  Institutions, such as banks and credit card companies, use these credit scores to determine the potential risk to the lender posed by extending money to a consumer.   In addition, it is used to provide a measure of protection against losses due to bad debt.  Taking credit scores and other information in to account, lenders determine who qualifies for a loan and at what interest rate they should charge, as well as what a credit limit should be set at. 

There are many different credit scoring systems in use, which means a person may have several different credit scores simultaneously. The most common and most talked about is the FICO score.  It ranges from 300 on the low end to 850 on the high end.  There are three types of credit for which a FICO score is generally used to determine credit worthiness: mortgages, automobile loans, and consumer credit.  Each lender can use their own criteria to determine who they lend to and who they don’t.  These criteria reflect the loan default risks inherent to these different types of lending. The score also depends on what credit-reporting agency the data are obtained from, because not all creditors report to all three and not all the information is accurate.  At any given time, there may be erroneous information on your credit report.  It is important to monitor your credit report frequently, especially because identity theft is so rampant.  The Fair Credit Act allows consumers to view their credit report from the three major credit-reporting agencies free once a year.  It is wise to take advantage of this provision.  Check out www.annualcreditreport.com.

Building a good credit history requires vigilance but can be achieved with determination.  The following steps can help build a solid credit history:

• Consider applying for credit at a local business. Remember not to borrow more than you can afford to repay.  When approved for credit with a local business, make sure that this information is reported to the three national credit-reporting agencies.

• Get a secured credit card.  A secured credit card works just like a regular credit card but a deposit is made to “secure” the card. Think of the deposit as insurance.  In case the debt is not repaid, the credit card company has the deposit.

• Make sure to comparison shop. Credit card companies charge different application fees, interest rates, and other costs.  Make sure you fully understand the terms and conditions of the agreement.  Be sure that you pay your bills on time and only use the card when you can afford the purchase.

Once good credit is established, it is important to monitor all the activity in order to keep it that way.  Particularly, be sure to always pay bills on time, and do not borrow more than can be repaid.  If an individual or a family member becomes sick or unemployed, make sure to contact all the creditors in order to work out a payment plan.

Why is interest charged on our credit accounts? 
To explain this point, let's ask a different question.  What is the incentive for a business or banking institution to give consumers a line of credit?  So, we can think of interest as the cost of the money you have borrowed.  Here again the point must be restated, it is very important to pay your credit card bills on time.  When using a credit account pay close attention to the amount of interest rate is charged to use that credit.  In addition, all consumers should read and understand the credit agreement that is sent with a credit card.  These agreements are contracts between the individual and the creditor, which allow for the liberal raising of interest rates at the creditors discretion.  In fact, they count on people not reading this agreement and using credit cards in ways that are not healthy for their financial life.

The interest rate can really increase the cost of the purchase price.  For example, let's say a credit card company charges you 20% interest.  If repayment takes a full year, that $100 clothing purchase has now cost $120.  Always try to limit the amount of credit used.  People who are not careful often find themselves in a lot of debt, especially when only making minimum balance payments.  By making only the minimum payment, consumers fall prey to the revolving interest rate trap of credit card issuers.

Far too many Americans depend on the use of credit to fund their current life styles because salaries have not kept up with inflation. According to James Scourlock, author of Maxed Out, “In the last generation, real inflation of adjusted income has risen by only one percent, while credit utilization has increased by 1000 percent!”

The consumer economy has been replaced by the financial economy, in which debt creates the growth.  Over the last ten years, GM made more money in financing adjustable-rate mortgages (ARMs) than they did in the sale and production of cars.  Even Target now earns 30% of the income from credit financing.  Again, this is growth fueled by unsustainable levels of debt, rather than fueled by savings or investment.  This may seem like a blinding glimpse of the obvious, but is borne out by some startling statistics.

Income hasn't kept up with basic costs of living, health care, housing, education, and energy.  In the 50's, most families survived economically on one income.  In the 70’s and 80’s, Mom went to work to support the same lifestyle to which families had become accustom.  In the 90's and 2000's families turned to home equity to support their profligate lifestyles, but as we approach 2010, the equity tank seems to be running dry.

Andrew Tobias, noted financial columnist, discusses this in his April 20, 2009 daily column:
[Let's] look at the the amount homeowners drew down in home equity loans three years ago versus last year.  This was money we had to borrow to keep the good times rolling.  Now it has stopped:  Quarter 1-2006, we had $223 billion in mortgage equity withdrawals.   Quarter 2-2008 it was $9.5 billion.  Is it any wonder we were in recession by 2008?  By the third and fourth quarters, there was no money to keep the treadmill going.  That $50 trillion in credit was shrinking fast.  We were imploding it.  Further, if you look at 2010 and 2011, we are getting ready for another huge wave of mortgage resets.

All this debt, of course, made the banks billions and billions of dollars. The “best” customer pays the minimum, generating huge profits for banks, card issuers, and other lending institutions.  However, this unsustainable level of debt has somehow taken the banking industry by surprise; only recently have these institutions realized consumers and small businesses can only be squeezed so hard.

David Rosenberg reports"the National Federation of Independent Business found in a poll that 28% of small firms said they had a line of credit or credit card limit cut back in the second half of 2008, 69% stated they are facing worse terms. A new FICO study found that 11% of US consumers -- 22 million people -- have had their credit lines cut or accounts closed even though they have been paying their bills on time and retain a solid rating."

What results from this is the current credit crisis.



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Information taken from the National Community Reinvestment Coalition: Credit and Debt Management Workshop, Part 1 [consumer fact sheet 1-14]