Credit Responsibility

Recently, the news media has given a lot of attention to the way banks, insurance companies and numerous other companies are using individual’s credit reports. Information in your credit report can impact everything from the rate you pay for credit to who will hire you. The media is questioning the fairness of this practice and they are leaving you with the impression that you are at the mercy of “big business”. “They” can do whatever they want to and there is nothing you can do to protect yourself from “these abusive practices.”

This is not the case. By understanding the impact of your actions on your credit report and becoming proactive, you will be using the existing system to your advantage.

Let’s begin by taking the question of “fairness” out of the discussion. In a perfect world everyone would be treated fairly. We would all be paid what we think we’re worth, we would pay no more in taxes than we think we should and we would never pay more for something than we think its worth. The reality is that nothing in life is fair and we deal with that in everything we do, everyday of our lives. We need to understand the system and then use that understanding to our benefit.

Banks are in business to make money. The marketplace makes them compete for your business by offering a more attractive rate than their competitors. If they were selling a product such as a car, we would have no problem understanding the concept that it costs more to produce a Mercedes than a Saturn and therefore we expect to pay more for the luxury car than basic transportation. A bank prices its loans based on its evaluation of the probability that a particular set of borrowers are going pay back on schedule what is owed. They set up profiles, based on credit scores, range of incomes, etc. They then analyze each profile to determine how it is going to perform. This is to attempt to predict what percentage of loans granted in each profile will go into default. From this the bank will decide what pricing should be used for each profile. The greater the probability of default for a particular profile, the higher the interest rate needs to be. A bank needs to earn enough money on the performing loans in the profile to make up for the ones that default.

A bank is looking at how you fit into a particular profile not why. A bank typically has no interest in knowing why your credit history is bad, the fact that it is bad is all that matters. Based on your credit history you will be put in a particular profile. The profile you fit into will be the deciding factor as to what your cost of borrowing will be.

We need to know what a bank looks at and how it evaluates the data so we can be sure to end up in a profile that gives us the lowest cost of credit.

The credit bureaus (companies that maintain the details of your credit) have begun to summarize your data in a number called a “credit score”. Once you understand what a credit bureau does and how your score is calculated, you’ll be equipped to use the system to your advantage.

Let’s begin by defining what a credit bureau is. When your credit report is generated by one of the credit bureaus (there are three; Trans Union, Experian & Equifax) all that happens is that they access your file in their database. A credit bureau is nothing more than a giant filing cabinet. Every lender or creditor you deal with periodically submits your history to the bureau. All the credit bureau does is organize this data and print it out. So a problem with your credit isn’t the fault of the reporting agency, it is based on the information the lender(s) supplied them. This is an important distinction. If there is information on your report that is inaccurate, contacting the credit bureau will be of little use. They are obligated to confirm the data in your file with the creditor that provided it. Since the creditor is the source of the bad data, they will naturally confirm that the data is correct. In order to correct an issue, you must go to the source of the problem, the lender.

This is not going to be an easy task. For starters, the lender’s staff is working from the position that their files are correct and you are wrong. Don’t take this personally. Most times this is in fact the case. Individuals make inquiries without being prepared. So if you are ever in the position that you need to have something updated, do your homework before making contact with the lender. Assemble whatever documentation you have regarding the issue. Collect your thoughts. Writing a set of notes will be helpful. When you get a customer service representative on the phone, don’t attack them with your problem. Give them your name and account number up front, so they can bring up their records before getting into a discussion with you. Then, calmly walk them through the issue, updating your notes with whatever additional information that is presented to you. Remember, you are not talking to “the lender”; you are talking to a person doing their job. The better the rapport you develop with this person, the more likely you will be able to quickly resolve the issue. At the end of the conversation, note down the name of the person you were talking to as well as the date and the outcome of the conversation. You will then write a follow up letter to the company, keeping a copy for yourself.

If the conversation ended with the lender promising to correct your credit profile, then request a copy of the updates that are being issued as well as a letter addressed to you, acknowledging what they are going to do. Diligence here is very important. The only person interested in following through to the end is you. Anyone else you’re dealing with is just doing a job. Maintaining a paper trail is the only way to guarantee resolution.  

In organizing your credit profile, the credit bureau will also generate your “credit score”. The score was created so a lender can have an impartial basis for deciding the creditworthiness of an applicant. Before the use of credit scores, underwriters would make a decision based on their experience, training and background. Since no two underwriters have the same backgrounds, either professionally or personally, consistent credit underwriting standards were difficult to maintain.

Maintaining a good credit score is the most important thing you can do to keep yourself financially healthy. In order to do this you need to understand what goes into the calculation of your credit score and secondly learn to ignore all the negative press regarding credit scores. From an individual’s prospective, you can’t be concerned about the validity of the credit score. The facts are, the score is generated, it is used by a variety of businesses and there is absolutely nothing an individual can do to change this system in the short term. As long as you understand the system and use it to your advantage, the validity issue no longer impacts you. All that really matters is that you get the credit you want, on the best possible terms.

The range of credit scores as well as the exact method of calculating the score is under constant revision, but the basic elements don’t change. By focusing in on these elements you will also maintain a creditworthy score. As a point of reference, scores range from 300 to 850. The higher the score the better, the best place to be is 720 or higher. Understanding the basic elements that are responsible for your score, will easily put you in the position of obtaining credit as needed.

Timely payments:

The most basic thing a lender is looking for is proof that you will live up to your side of the deal when you are lent money. The deal is simple. The lender agrees to advance you a sum of money, in return you agree to pay it back with a predetermined fee for the service (the interest rate) through a series of installments (payments). If you have a history of not paying lenders back and the lenders are forced to use collection agencies or legal recourse to collect what’s owed, then it’s pretty obvious that a new lender would not be inclined to conduct business with you. If you make your payments when you feel like it, ignoring the agreed upon payment schedule you made with the lender, a new lender will anticipate a similar schedule with any new loan and treat you accordingly.  

The first step in developing and maintaining a good credit score is to pay your debts on time. How do you do this if you run into a financial jam? If it’s a small problem where you have to pay a few bills a little late, than it’s simply a matter of prioritizing. Installment debt, like car loans, and revolving debt, like credit cards, appear in you credit profile. Regular monthly expenses such as utility bills and rent do not. So by choosing properly which bills to pay, the small problem has no impact on your credit score. If the problem is larger however, than the modern day version of “borrowing from Peter to pay Paul” is the solution. Using you ability to take cash advances from your credit cards, borrow from one card to pay the minimum on your bills. If need be, borrow from more than one card. Each creditor will be happy to extend you the additional credit and no one is paid late. As an added bonus, the cost of this approach is less than paying late charges. Lesson 1: Pay your bills on time even if it means being creative to do it.

Volume of data:

The next point to keep in mind is that the more information available, the better the calculation of the score will be. If you have 2 credit cards and you make a late payment on one of then, there will be a major drop in your score. It doesn’t matter if the late payment is an error; the short term impact is that there is a drop in your score. Now if you have 20 credit cards and you make a late payment on one of them, the impact on your score will be much less. There is simply more data for the program to work with. I’m not suggesting you use all these cards, just have them open and keep no balance on them.

If you are working on paying down your debts, don’t close accounts as you pay them off. Keep the accounts open without an outstanding balance on them. The net benefit will be a higher credit score. If you feel having all this available credit is a temptation you would rather not have, them put the cards in a safe deposit box, hand them over to a family member or simply destroy them without closing the account. Lesson 2: Make sure your credit profile is long; the more data the better.

Availability of credit:

The way you pay your bills has the most impact on your credit score. It makes up roughly 35% of your score. The second most important component (representing roughly 30%) is how you use your credit. That is how high a percentage of your available credit is being used. Building on the previous example of having 2 credit cards, let’s say each card has a $3,000 credit limit and your total outstanding balance is $4,000. You are using 67% of your available credit ($4,000/$6,000). Now if you had 4 more cards with zero balances and credit limits of $3,000 each, your percentage dropped to 22% ($4,000/$18,000). Your total amount of debt is no different but since you have more credit available that is not being used, you become a better credit risk and end up with a higher score. Lesson 3: The more available credit you have, the higher your credit score will be.

Length of Credit History:

The longer your credit history is, the better. So the time to focus on your credit is not when you are deciding to make a major purchase, such as a house, it is now. You can never start to build a credit history too early. The length of your credit history contributes roughly 15% to your score.

All history is not the same. The most recent past has the greater weight. So if you have any credit problems, address them as soon as possible so you can begin to build up a positive credit history in preparation of a major purchase in the future. “Time heals all wounds” applies to a wounded credit history. Lesson 4: Identify and address any credit issues as soon as possible.

Credit Inquires:

Your credit profile does not include any time you have been denied credit. It only contains whatever outstanding credit you have, both good and bad, and lists the businesses that have requested your credit report. There are two types of businesses that can access your report, with your permission. Those that extend credit, such as a bank, and those that are providing you with some form of service, such as an insurance company or utility. From a credit standpoint only those businesses that extend credit have an impact. The implication is that if you are regularly granting permission for lenders to review your credit report and no new credit is being issued then it appears that you are being declined for the credit requested.

The exception to this rule is in certain cases inquiries grouped in a short period of time can be considered one inquiry. For example multiple inquiries from banks and mortgage companies within a 30 day period are considered one inquiry. The presumption is that the individual is in the process of buying a home and is shopping around. The same is true for leasing companies and banks. Multiple inquires, within a 10 day period, from leasing companies and banks is considered to be one inquiry for an individual who is apparently shopping for a car.

Don’t try to build up your credit all at once. Spread out your applications for credit as much as possible. Take advantage of applying for a store credit card when making a major purchase. You’ll get the credit on the spot easily with only that inquiry. If you’re looking to get another MasterCard or Visa, fine go ahead. Don’t try to get 3 in one month, that could work against you.

The impact of excessive inquiries is overblown in most people’s minds. It only contributes to 10% of your score and has the most impact on people with short or poor credit histories. Lesson 5: Don’t needlessly apply for credit; apply only when it’s reasonable to expect to be approved.

Know the important details

Whenever you borrow money you are required to sign a lengthy document that describes all the obligations you have to the lender and the recourse the lender has if you don’t make the payments in the agreed upon matter, pay late or default on the agreement. It’s easy for me to say read it all before signing, but I’m not going to do that. The agreement is too long and detailed for most of us to go through so I’m going to recommend you focus on a few key items.

Let’s first look at an installment loan. Start by confirming that the loan is for the amount it’s supposed to be. Are there any upfront expenses associated with this loan and are the expenses what you expected them to be? Is the interest rate, term of the loan and the monthly payment correct? Are there any additional monthly charges that are being added in that you weren’t aware of until now, such as a maintenance agreement or some form of insurance?

It’s at this point that people get into trouble because they don’t take the next step. You want to note what day of the month the payment is due. Is there a grace period and for how long? If payment is not made during the grace period, what is the late charge? In the event you want to pay off the loan early, is there some form of fee, a prepayment penalty, to do it? For the typical consumer installment loan, you now have an adequate understanding of what you’re signing. If you feel comfortable that you can handle all the conditions of this loan, then go ahead and sign for it. If you find yourself uncomfortable with the details, that is, the details as written are substantially different from what you were told, then go somewhere else for the loan.

Revolving credit, overdraft checking privileges and credit cards need to be looked at differently. Overdraft privileges typically are straightforward. You’re given an overdraft limit, which you can draw on simply by writing a check. Minimum payments are automatically deducted from your checking account when due. You should be aware what the interest rate is and how the minimum payment is calculated. As you use the overdraft you will need to watch two things. First, don’t inadvertently exceed your credit limit. Each bank handles this differently. If you’re a good customer, they may just automatically increase your credit limit. It would not be wise to make this assumption, since the bank is never going to be under any obligation to afford you this courtesy. They can begin to bounce checks, embarrassing you as well as having your account debited for bounced check charges. This can then cause additional checks to bounce, again with additional charges. The second thing you will need to watch is that there is enough of a balance in your checking account to cover the minimum payment when the debit occurs. You can’t assume that your bank will simply advance you the money off of the overdraft. Some will, but most will not.

With credit cards, in addition to checking the interest rate and noting how they calculate the minimum payment, you need to watch the due date on each month’s statement. Although it’s not likely that the due date will change each month, it is likely that you may receive your statement at a different time each month. A statement could be delayed leaving the creditor, there could be holidays in the cycle that delayed the statement’s printing or the postal service could have used up more days than normal. Whatever the reason, it is still your responsibility to get the payment to them before the due date. Always use the due date, not the grace period. Technically your payment is on time once it is delivered to the creditor; unfortunately it is nearly impossible to prove when they received your check. It’s much safer to use the due date for paying and leave the grace period for the post office to deliver and the creditor to process your payment. Remember, our goal is to maintain the best credit history possible with as little work as possible. We’ve already addressed the work involved in correcting something in your credit file. Simply checking due dates reduces the chances of having the problem in the first place. Lesson 6: When you borrow money, know what you’re agreeing to.

Use credit cards wisely

Ideally, you pay all your credit card bills at the end of the month, carrying no outstanding balances over to the following month. In the real world, this rarely happens, so you want to use the system to keep your interest charges the lowest. A common solution is to move your balances to a low interest credit card. While this is a good idea you need to do more than that. New purchases should be made on a card you have that carries no balance with the intent of paying off the entire balance at the end of the billing cycle.

What if you don’t have the money to do it? Pay off the balance with a cash advance from a different card. If you charge a purchase on a card with no outstanding balance and pay the full balance at the end of the billing cycle, there is no interest charged.

The entire balance on a credit card may not be subject to the same interest rate. You will sometimes see a credit card that has one interest for the first $1,000 balance and then a reduced interest for any balance above that. Or, you may see the reverse occur. If you take advantage of one of the “balance transfer” offers that nearly all the credit card companies offer, this will happen. A typical offer may read, “As a preferred customer we are offering you a 1.0% rate on all cash advances from you MasterCard that are used to pay off your higher interest rate creditors. Just used the attached checks.” What happens here is that only the balances that were transferred will be subject to the lower interest rate. Any additional advances or charges will be at whatever the normal rate is of this particular card. When you begin to pay down the balance on this card an interesting thing occurs. Any payment you make towards the balance is used to pay down the balance on the special 1.0% rate, not the balance that is earning the normal rate. You do not have the option to direct how the payment is distributed. Again it’s better to use a card with no carry over balance for new purchase with the intent of paying off the entire balance of that card when the bill comes. By using this method, you are in a better position to control the cost of your borrowing.  Lesson 7: Make sure you’re always paying the lowest interest rate available to you.

Don’t co-sign for a loan

Avoid co-signing on a loan for anybody, no matter how close a relation or friend. When you co-sign for someone you are exposing yourself to someone else’s payment history. Any late payments they make will appear in your credit profile and impact your credit score. The creditor will not even notify you that the payments are late until the problem becomes severe and they come looking for you to make good on the loan. If you want to help someone out, be the primary borrower and have the bills sent directly to you. This way you can make sure that the payments are made in a timely fashion, even if it means paying them yourself. Lesson 8: Never co-sign a loan for anybody.

Don’t run away from trouble

You run into a financial problem. You’re out of work for an extended period of time, maybe it’s medical related. Whatever the reason, you need to make contact with your creditors before you fall behind in your payments. Creditors are more willing to work with you in developing a payment plan when you approach them while payments are still current. If they’re chasing you for payment, there isn’t as much of an incentive to work with you. If you are in a bind, you need to know how much relief you need and for how long before you approach the lenders. You don’t want to make promises you can’t keep. If you end up in a situation that you feel is more involved than you think you can handle by yourself, then hire a professional to work with you. Again, don’t wait until you are behind in your payments. With or without professional help, you will have more options by addressing the problem earlier rather than later. Lesson 9: Ignoring a problem doesn’t make it go away; it only makes it worse.

Avoid major changes in your borrowing habits

Creditors are sensitive to drastic changes to your spending habits. You’ve may have run into a situation like this. You decide to make a major purchase on your credit card, something you haven’t done recently. When the store attempts credit authorization, they can’t get it before you get on the phone with the credit card company. In a situation like this, they are simply confirming that you are the cardholder and not some thief who just stole your wallet and is beginning to use your charge card.

Creditors are beginning to use a similar approach as an early warning to collection problems. If you normally carry a small balance, or no balance, on your credit cards and suddenly you are carrying higher and higher balances you may see your creditors begin to reduce your credit limits. They are seeing the borrowing pattern of someone who may be in a tight financial situation. This moves you into a profile of a borrower that will not be able to continue making timely payments. The checks and balances that the industry put in place to defend against fraud are now being used as an early warning signal of borrowers whose creditworthiness may be in jeopardy.

Perhaps there has been a late payment or two at the same time. This might trigger your credit limit freezing at the point where it currently is. There could be an increase in your interest rate as well as higher minimum payments. Because you now fit a different profile, the lender is responding accordingly.

If you do run into a financial bind, try not to make drastic changes to your borrowing habits. For instance, if you lose your job, usually the first reaction is to supplement your income by drawing off your savings and as a last resort drawing off your available credit. Resist that instinct. Make up your monthly cash shortfall through a combination of increasing credit card balances, by charging more of your everyday purchases and making minimum payments, drawing cash advances and possibly some draw down off your savings. By using some credit early on, instead of using cash, you give yourself more options. If for some reason your availability to credit becomes restricted, you still have your cash to pay bills with. If some creditors increase the minimum payments they want, you have your savings to help.

It is during temporary situations, such as a break in employment, that all the work you’ve done to keep your credit score high, becomes a major help. It allows you to focus on the immediate problem, finding a new job. Once things are back to normal, you can then concentrate on paying down whatever debt you took on. Lesson 10: When faced with a problem; don’t draw any unnecessary attention to yourself.

Credit is the lifeblood of our society. By learning these 10 lessons you will always have credit at your disposal.

• Lesson 1: Pay your bills on time even if it means being creative to do it.

• Lesson 2: Make sure your credit profile is long, the more data the better.

• Lesson 3: The more available credit you have, the higher your credit score will be.

• Lesson 4: Identify and address any credit issues as soon as possible.

• Lesson 5: Don’t needlessly apply for credit; apply only when it’s reasonable to expect to be approved.

• Lesson 6: When you borrow money, know what you’re agreeing to.

• Lesson 7: Make sure you’re always paying the lowest interest rate available to you.

• Lesson 8: Never co-sign a loan for anybody.

• Lesson 9: Ignoring a problem doesn’t make it go away; it only makes it worse.

• Lesson 10: When faced with a problem; don’t draw any unnecessary attention to yourself.

Giving your personal finances the attention they deserve is one of the most important things that you can do to improve your quality of life.