To Borrow or Not To Borrow, that is the (steward’s) Question!
First let’s explore what credit actually is. We all know intuitively what it is but just out of curiosity I thought I would get out “Mr. Webster” and see what he has to say. My Mr. Webster says that credit is “time given for payment for goods sold on trust”. Not really what I expected.
As all of you are fully aware, credit is readily available in the world today. The cost of course is the interest we pay but there may be some other associated costs such as closing costs, appraisal fees, inspection fees, title searches, and attorney fees in the case of a mortgage loan.
The reason of course for the abundant supply of credit is that there is a demand. But why are the people OF the world so anxious to borrow so much money? What’s the fundamental reason? When I ask this question, most people are usually too polite to say “are you stupid or something, it’s because we don’t have it”. Well that isn’t really the right answer. If we go back and look at the definition of credit we see that it’s really a timing issue. Yes it’s true they don’t have the money but it’s that they don’t have it RIGHT NOW. And, they simply can’t wait till they have it saved, or till they get a raise, or till they get a new job or another job, or till they get their inheritance from “Uncle Frank” or till they win the lottery.
If people (of the world) had to wait till they had enough money saved to buy a home, they’d all be living in rental property. If people (of the world) had to wait till they had enough money saved to buy a car, they’d all be riding bikes or walking. Credit opens up a whole world of opportunities: to own a home, to buy a car, to start a business (small business is the lifeblood of the US economy), to go to college (have we given up on the idea of working your way through). And the really big one, credit opens up the opportunity to LIVE BEYOND OUR MEANS (at least in the short run).
There are all kinds of people out there just dying to let us use their money but they expect us to pay them back with interest unless we’re borrowing from our rich “Uncle Frank”. He may not expect us to pay interest or maybe he doesn’t even expect us to pay him back at all. For everybody else out there in the real world, lending is business, a really big business. The people in the lending business are faced with a really big question whenever they are approached by a prospective borrower. What do you suppose that is? You know the answer. How can I tell if this borrower is likely to pay me back? Let’s say I come to you and ask to borrow $1000. What are you going to want to know about me before you give me $1000? I know I’m extremely attractive, and I’m very smart, and I almost always smell good. What else might you want to know? Make a list: ________________________________________________________________
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Hey, some of that stuff is kind of personal. Are you sure you need to know all that? Actually, all the information you want to know about me is already available. There are three major credit reporting companies out there in the real world that collect this kind of information and make it available to lenders (for a fee of course) to help them with this question about how likely I am to pay back the loan. The companies are: Experian, Equifax, and TransUnion. A forth company, ChexSystem, collects, tracks, and reports information about our bank and credit union transactions and performance.
To make life easier for everybody in the lending business, back in the 1960s, a company by the name of “Fair Isaac” developed a mathematical formula or algorithm for calculating what they called a FICO credit risk score. The data used in their formula is supplied by the credit reporting companies. The FICO formula is a secret of course and some of the reporting companies have developed their own proprietary formulas over the years. In fact, the three companies have gotten together recently and come up with a new formula altogether.
Although we don’t know the exact make up of the formula, we do know what factors are considered. Here’s what Fair Isaac uses in its formula:
- Payment history. Are you paying your bills on time? The most recent two years are most important. It accounts for 35% of the score.
- Amount owed accounts for 30% of the score. Actually the important thing here is the ratio of amount we owe compared with the amount we could borrow. All credit cards have a credit limit. Divide the current balance by the limit to get this ratio. It’s best if you keep this ratio under 50% and some would say keep it under 30%.
- Length of credit history accounts for 15% of the score. That is, how long have you been using any kind of credit. When I got married 58 years ago there weren’t such things as credit cards but there were store accounts so we applied for and got a Penney’s charge account.
- New credit accounts for 10% of the score. If you have opened a whole bunch of new accounts recently, it will have a negative impact on your credit score.
- Credit diversification accounts for the remaining 10% of your credit score. For some reason, if you are using several different types of credit (mortgage, credit card, store accounts, car loans, etc.) it impacts your score positively.
I know what you are thinking. This is all very interesting but so what? Why is the credit score so important? What’s the big deal?
Sorry, you’ll have to wait till next week for the answer.