Credit and how credit is reported remains elusive for many people. First, credit is the term used to describe a mutually beneficial transaction between a borrower and a lender. The borrower and lender will agree upon specific terms before the transaction is processed. The terms of credit include interest rate, amount, and payments.
There are two types of credit, revolving or installment. Credit is either unsecured or secured. Secured credit is backed by collateral and if the borrower fails to pay, the lender has rights to seize the collateral.
REVOLVING CREDIT is simply a line of credit with an open-ended use of the amount extended. The “limit” is the maximum amount the borrower is granted. Usually the minimum payment options are determined as a percentage of the amount borrowed and due on a recurring date. For example, if your limit is 10,000 and you borrowed 1000, and your creditor has a minimum monthly payment set at 2% of your balance, you would have to pay 20 every month to keep your account in good standing on or before the payment due date. As long as the borrower adheres to the terms of the credit offer, the lender will renew or continue the relationship.
Secured revolving credit include Home Equity lines, Commercial Property lines of credit, and any line backed by a tangible asset. For small business owners, intangible assets such as accounts receivable or inventory can also act as collateral.
Unsecured revolving credit is backed solely by the borrower’s personal guarantee. Credit cards, and personal lines of credit represent the categories of unsecured credit products offered by lenders today.
INSTALLMENT CREDIT is a loan with a one time disbursement of funds with payments made in monthly installments within a specified period of time. An amortization schedule lists the exact figures of interest and principal of each payment until the initial amount borrowed is zero.
Common secured installment loans include Auto Loans, Home Loans, Boat Loans, and any credit product backed by collateral. Student loans are considered secured since the Federal government backs these loans in the event of default.
Unsecured Installment credit is also known as a signature loan or a personal loan.
The cost of credit to the borrower is determined by the Interest rate which measures through a variety of factors the overall risk to the lender, risk meaning will the borrower pay back the funds lent.
Interest rates charged on credit can be fixed or variable with variations of both. A fixed rate is a specified flat rate that does not change despite market conditions. A variable rate is usually tied to a financial index within the economy.
With a fixed rate, the lender assumes the interest rate risk while the borrower assumes the risk with a variable rate. Additional terms could exist in an installment credit agreement with variations including higher interest rates after a specificied period. Some revolving credit arrangements can offer an introductory rate or “teaser” rate, reverting to the rate outlined in the terms and conditions once the introductory period is over.
In America, credit is reported to three agencies known as Credit Bureaus; Equifax, Transunion, and Experian. Each bureau has a method to determine your Fair Isaac Credit Score, commonly known as FICO. This score is measured by several basic concepts and ranges from 150-930. These concepts include payment history as reported by past lenders, number of inquiries for credit, debt to credit ratio (current balances/credit limits), and the number of recent accounts. It’s important to note your payment history is tracked primarily by your social security number/taxpayer identification number. Personal information such as address, name(s) , employers, and DOB acts as measures against fraud.
A score in the upwards of 740 is considered “A” credit, “B” ranges between 650-739, “C” 550-649, and “D” any score below 549. Most lenders will not offer unsecured products to individuals with “C” or “D” credit. If you have never borrowed, you will not have a credit score and most lenders view no credit as bad credit, so it’s important to start establishing your credit.
Your chance to borrow increases with a higher credit rating, and works inversely with interest rates. Higher scores will potentially lead to lower interest rates. ECOA, the equal credit opportunity act passed in 1974, eliminated lender discrimination on the basis of race, religion, sex, creed(national origin), age, marital status, or receipt of public assistance.