Chapter One
The Lowdown on Credit Essentials: Just What You Need to Know In This Chapter
* Seeing yourself as lenders see you
* Understanding credit reports and credit scores
* Establishing credit for the first time
* Handling mortgage problems
* Living happily ever after
Whatever did people do before there was credit? In the olden days, it was much more difficult for the average person to buy the goods and services that are taken for granted today - things like a car, a home, and a college education, to name a few. Imagine if first-time home-buyers had to save $267,000 (the national average for the cost of a new home in 2008, according to the Federal Housing Finance Board) before taking ownership and stepping over the threshold. If that were the case, they''d likely be using walkers to enter their new abodes.
Credit is a powerful tool. It can be used to move mountains. Unfortunately, it can also bury you beneath one if you use it improperly. Credit doesn''t come with an instruction manual or a warning label. The subject generally isn''t well-taught in schools or, for that matter, in the family, either. So where do you get an understanding of this genie in a bottle before you make your three wishes? You''re holding the answer in your hands.
For nearly two decades I''ve been helping people just like you recover from the aftereffects of credit gone bad. The best of my experience is contained within the pages of this book. I firmly believe that if you know the rules of the credit game, you stand a much better chance of getting a good score. We all make mistakes, and this applies to credit use as much as anything else. The important thing is to know how to recover from your mistakes without compounding the damage.
I start with the basics so you can better understand the principles and concepts behind credit. Consider this chapter your jumping-off point to this book and to the world of credit. My goal is to make your credit the best it can be and keep it that way. Not just for the sake of having good credit, but so you can live the American dream of having a decent job, a place to call home, and whatever else you desire for yourself and those you love.
Defining Credit: Spending Tomorrow''s Money Today
Credit has its origins in the Latin word credo, which means, "I believe." The real underlying issues of credit are: Do you do what you promise? Are you believable and trustworthy? Have you worked hard to have a good reputation? Little is more precious to a person than being believed - and that''s what credit is all about.
You (and Webster''s) can also define credit as:
Recognition given for some action or quality; a source of pride or honor; trustworthiness; credibility
Permission for a customer to have goods or services that will be paid for at a later date
The reputation of a person or firm for paying bills or other financial obligations
The concept of credit is simple: You receive something now in return for your promise to pay for it later. Credit doesn''t increase your income. It allows you to conveniently spend money that you''ve already saved - or to spend the money today that you know you''ll earn tomorrow.
Because businesses make money when you use credit, they encourage you to use it as often as possible. In order for creditors to make as much money as possible, they want you to spend as much as you can, as fast as you can. Helping you to spend your future earnings today is their basic plan. This plan may make them very happy - but it may not do the same for you.
Many types of credit are available to consumers today, which is no surprise to you. I suspect you receive as many offers for various types of credit cards and lines of credit as I do. But despite the endless variations and terms that seem to exist, most credit can be classified as one of two major types:
Secured credit: As the name implies, security is involved - that is, the lender has some protection if you default on the loan. Your secured loan is backed by property, not just your word. House mortgages and car loans fall in this category. Generally, the interest rates for secured credit are lower and the term (the length of time before you have to pay it all off) may be longer because the risk of loss is lessened by the lender''s ability to take whatever you put up for security.
Unsecured credit: This type of credit is usually more expensive, shorter-term, and considered a higher risk by the lender. Because it is backed by your promise to repay it - but not by an asset - lenders are more vulnerable if you default. Credit cards fall into this category.
Chances are, you''ve always looked at credit from your own perspective - the viewpoint of the borrower. From where you''re standing, you may be the customer who should be catered to. Consumer spending is two-thirds of the U.S economy, and much of that is generated by using lines of credit or credit cards. Whether you use credit as a convenience or because you need to spread out your payments, you keep the economy humming and people employed. Right? From the lender''s perspective, however, you represent a risk. Yes, your business is sought after, but the lender takes a chance by giving you something now for a promise to pay later. If you fail to keep your promise, the lender loses.
The degree of doubt between the lender making money and losing money dictates the terms of the credit. But how does a lender gauge the likelihood of your paying on time and as promised? The lender needs to know three things about you to gauge the risk you represent:
Your character: Do you do what you promise? Are you reliable and honest?
Your capacity: How much debt can you handle given your income and other obligations?
Your collateral: What cash or property could be used to repay the debt if your income dries up?
But where can this information be had - especially if the lender doesn''t know your sterling attributes firsthand? The answer: your credit report and, increasingly, your credit score. That''s why, before you open up that line of credit that allows you to buy the new dining room suite on a 90-day-same-as-cash special, you have to fill out and sign some paperwork and wait a few minutes for your credit to check out.
Sometimes, however, an unscrupulous creditor may try to take advantage of you and charge you more than the market price for the credit you want. Why? Because they like to make money. So, how do you know if you''re being overcharged? The same way the lenders decide whether to offer you credit and what to charge you for it: by knowing what''s in your credit report and your credit score.
Meeting the Cast of Characters in the Credit Story
Before I delve into the saga of credit and all its complicated plot twists, allow me to introduce the characters. In most lending transactions, three players have lead roles: the buyer (that''s you), the lender, and the credit reporter.
The buyer: I want that now!
The cycle of credit begins with the buyer - a person who wants something (that''s you!). A house, a car, a plasma TV ... it doesn''t matter what it is that you want. The definitive factor is that paying for it upfront is either inconvenient or impossible. Maybe you just don''t have the cash with you and you want the item now, perhaps because it''s on sale. Or maybe you haven''t even earned the money to pay for the purchase, but you know you will and you don''t want to pass up the chance.
"Hmm," you calculate as you gaze longingly at the coveted find. "I really want to get this now. If I wait until I have the money, it might be sold or the price might have gone up, so it only makes sense to buy it now." Or, if you''re generous (or making excuses), you might say, "My sweetie would love this - and me - if I bought this. Who cares that I don''t have the money right now? I will someday. I just know it."
Enter creditors, stage right.
The creditors: Heroes to the rescue
The creditor spots your desire a mile away, and it stirs the compassionate capitalist within him. "Hey," says the person with the power to extend you credit, "no need for you to do without. We have financing. We just need to take down a little information, do a quick credit check, and you can walk out the door with this thing you''re lusting for."
If businesses can''t sell you something or lend you money, they can''t make a profit. So believe it or not, they really do want to loan you money. But there''s that risk factor: They need to find out how risky a proposition you may be. In order to get the rundown on your credit risk, they call the credit bureau.
Enter credit bureau, stage left.
The credit bureaus: In a supporting role
The merchant most likely contacts one of three major credit-reporting bureaus - Equifax, Experian, or TransUnion - to get the credit lowdown on you. The credit bureaus make the current lending system work by providing fast, reliable, and inexpensive information about you to lenders and others.
REMEMBER
The information in your credit report is reported by lenders doing business with one or more bureaus and put into what is the equivalent of your electronic credit history file folder. This file of data is called your credit report, and I devote a good portion of this book to credit reports. (See Chapter 2 for the full-blown story.)
Over the years, as more information has built up in credit reports and faster decision-making has been found to result in more sales, lenders have increasingly looked for shortcuts in the underwriting process that still offer protection from bad lending decisions. This need was met by the credit score, a shorthand version of all the information in your credit report. The credit score predicts the likelihood of your defaulting on a loan. The lower the score, the more likely you are to default. The higher the score, the better the odds for an on-time payback. By far, the most-used score today is the FICO score, which I cover in detail in Chapter 2. FICO scores range from 300 to 850.
In Chapter 5, I tell you about an additional 20 bureaus that have information about you. They''re known as the national specialty consumer reporting bureaus, and they contain information on everything from how much you gamble to what medical condition you may have.
Understanding the Consequences of Bad Credit
Over the last 17 years, I''ve seen the underside of credit up close. During that time, I started a local credit-counseling agency that grew into a regional consumer resource and helped thousands of individuals and couples from all walks of life with credit issues. During the last few years, I''ve gotten questions from consumers just like you from all over the country - questions about their credit-related problems and opportunities - through my weekly "Debt Advisor" column that appears in newspapers and on the financial megasite Bankrate.com. I''ve witnessed time and again the devastating effects of credit gone bad.
Aside from the obvious increase in borrowing costs and maybe a hassle getting a credit card, what are the very real costs of bad credit? The extra interest you have to pay is only the tip of the iceberg. The real cost of bad credit is in reduced opportunities, family stress, and having to associate with lenders who, more often than not, see you as a mark to be taken for a ride and dumped before you do it to them. And, believe me, they''re better at it than you are. In this section, I fill you in on some of the unpleasant consequences of bad credit.
Paying fees
From your perspective as the borrower in trouble, paying fees makes no sense at all. You''re having a short-term problem making ends meet, so what do your creditors do to help you? They add some fat fees onto your balance. Thank you very much.
How do these fees help you? They don''t. The fees helps the creditor in two ways:
They focus your attention on their bill, instead of someone else''s.
The creditor gets compensated for the extra risk you''ve just become.
As bad as the fees can be on your credit cards, they can be even worse on your secured loans. If you fall three months behind in your house payment, you can be hit with huge fees to the tune of thousands of dollars.
WARNING!
Secured lenders tend to be low-key. Don''t let that calm voice or polite, non-threatening letter lull you into complacency. They''re low-key because they don''t have to shout - they''ll very quietly take your home or other collateral, unlike the credit-card guys, who can be heard from across the street. Pay attention to the quiet guy, and take action.
TIP
Late fees, over-limit fees, legal fees, repo fees, penalty fees, deficiency payments, and default rates: When the fees show up, it''s time to get serious. Call the creditor and ask to have the fees waived. Explain your plan to get current (make any past-due payments) and let them know that you need their help, not their fees. Chapter 13 of this book helps you put together a budget so you know exactly how much you can afford. If you have difficulty developing a budget, your creditors may accept a debt-management plan, which you work out with the help of a credit-counseling agency (see Chapter 3). Take action early enough in the game while you and your account are still considered valuable assets, and you''re more likely to have success getting the fees removed.
Being charged higher interest rates
Consider two home-buyers: one with a credit score of 760, the other with a credit score of 659. The happy new homeowner with the lower score won''t be so happy to learn that, because of that lower score, he''ll pay more than $90,000 more in interest over the life of the loan. Why? Because the mortgage company offers an interest rate of 5.3 percent to the individual with the 760 score, and an interest rate of 6.6 percent to the borrower with the 659 score.
The concept works basically the same in any lending situation. What impact would these scores have on a new car loan? A 36-month interest rate is more than 50 percent higher for the person with the 659 score versus the 760 score!
WARNING!
Your credit score is based on your credit actions yesterday, last year, and maybe even ten years ago. If you miss a payment or two, that low-interest-rate credit card on which you''re carrying a high balance can take your breath away. Watch the rate climb to the mid- to upper-20s or even 30-something - percent, that is! After all, you made a mistake and might stop paying altogether. So the lender is going to make money on interest while it can.
You think that getting your interest rate hiked for a minor infraction is unfair? That''s not the end of it. Under the policy of universal default, if you have an issue with one lender, all your other lenders can hike their rates as well. Yes, even though you''re still paying the others on time and as agreed! In fact, some companies even use a deteriorated credit score as reason to escalate your rates to the penalty level. Even though you''re paying that loan on time, a change in your credit score (perhaps from too many account inquiries or carrying higher balances) gives the creditor that has a universal default policy full rein to hike up your interest rates. All the more reason to pay all bills on time and keep track of your credit report and credit score on a regular basis.
Losing employment opportunities
Prospective lenders aren''t the only ones who judge you based on your credit report and credit score. Potential employers check out your credit report, too. Why is that, you ask? Businesses reason that the way you handle your finances is a reflection of your behavior in other areas of your life. If you''re late paying your bills, you may be late for work. If you default on your car loan, you may not follow through with an important assignment.
(Continues...)
Excerpted from Credit Repair Kit For Dummiesby Steve Bucci Copyright © 2008 by Steve Bucci. Excerpted by permission.
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