At its most basic level, credit is the ability to borrow money. That's it. Most people don't have an extra $250K lying around to go out and purchase a home in cash. Instead, we use a loan to get into the house today and eventually pay it off in the future; maybe 15, 20 or 30 years later.
There are two types of credit that most people use, credit cards and loans. Credit cards give you revolving access to a fixed amount of money, which is known as a credit limit. Loans on the other hand let you borrow a lump sum of money for a longer period of time. As mentioned above, some of the more common loans include: home, auto and business.
Credit, if used wisely, is a great financial tool that can help you achieve a wide variety of financial goals. If it is not used wisely it can be your worst enemy. That is why effectively managing your money by using a detailed spending plan, complete with goals and other benchmarks, is so important.
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Understanding Your Credit
For a lot of people, their understanding of credit simply means which credit card to pull out to make the purchase of the day. It can be very convenient. After all, there is no need to stop by the ATM machine or count out change. This is the way it was designed to be, simple, fast and convenient. However, there is more to learn about credit than simply being a passive user. By learning more, you help yourself by ensuring that you receive the most favorable terms.
The Five C's
When a credit card company or lender is considering granting you credit they consider the "Five C's" of credit before approving you.
- CAPACITY: This is your ability to repay the loan. They want to know if you, as the borrower, can afford to make the monthly payments based upon your current income.
- CAPTIAL: This is the borrower's bank account balances, stocks, bonds, mutual funds, private property (house or car) and an overall outlook of the borrower's debt load.
- CONDITIONS: This is the state and national economy and the overall availability of money to lend. When interest rates are lower there is usually more money to lend. When economic times are hard credit is much harder to get.
- COLLATERAL: This is an asset that is pledged against the loan. This usually gives a lender more comfort when approving a loan. Thus, if you default (do not pay) on the loan, the lender can sell the pledged asset(s).
- CHARACTER: This is the when the lender analyzes the borrower's prior history of repaying other loans. Usually, this information is obtained within the borrower's credit report, which also includes a FICO® score.