Five Important Credit Concepts

I just finished several lectures about credit for my Rutgers University class. Understanding the wise use of credit does not have to be difficult. While there are many credit-related terms such as APR, debt-to-income ratio, and FICO score, there are only a handful of “evergreen” credit concepts. Below are five things that everyone needs to know about credit:

¨      Credit Is OPM (Other People’s Money)-When people use credit, they are earmarking their future income to pay for today’s spending. A 20% debt-to-income ratio effectively means that one day’s pay is already “spoken for.”

¨      People Spend More Money with Plastic- When people swipe a credit (or debit) card, they are disconnected from the “loss” they feel when they take cash out of their wallet to pay for something on the spot. Using credit “hurts” less.

¨      Lower Monthly Payments Come with a Cost- When people make lower monthly payments by stretching out the time to repay a loan (e.g., a 5-year car loan vs. a 3-year loan), they pay more interest over the life of the loan. Other common ways that people lower monthly payments are interest-only loans and paying the minimum payment due on credit cards.

¨      Your Credit Past is Your Credit Future- When people use credit, their payment history is their “financial reputation” and shapes future opportunities such as new loans, the interest rate charged on loans, auto insurance premiums, and rental housing options. More than a third (35%) of a FICO credit score is based on past debt repayment history.

¨      High-Risk Borrowers Pay More for Credit- When people have a credit score lower than the mid 700s (depending on a lender’s risk criteria), they pay more for credit than “prime” borrowers and are offered fewer credit-related opportunities. Risk-based pricing by lenders mean that a low credit score costs extra. Often, lenders use tiered interest rates and will not quote an interest rate on a loan until they’ve examined a prospective borrower’s credit history.