Credit is most frequently extended by department stores, finance companies, oil companies, credit unions, commercial banks and credit card companies. Those who extend credit are called creditors.
In order for credit to be extended to you, a creditor looks at two things:
You as a risk. Each creditor has different ways of evaluating applications for credit. By reviewing factors such as income, length of employment, how long you’ve lived at one residence, previous credit history, amount of outstanding debts, stability of your checking and savings accounts, number of dependents and so on, creditors can determine, to a certain degree, whether you will repay the amount borrowed over a certain period of time.
What you are purchasing as collateral. Items such as furniture and appliances are easy for a creditor to repossess if you fail to make the credit payments. Therefore, since a creditor has less to lose in the long run, credit may be extended to even those with a questionable ability to pay when it comes to purchases like TVs and refrigerators.
When a home has been posted as collateral for a loan, the foreclosure process can be costly and time-consuming.
The lender assumes a greater amount of risk at a lower interest rate. Therefore, the lender is going to evaluate you and your credit history more carefully when you’re trying to buy a house.
How do you establish a good credit history?
Establishing a good credit history is actually pretty simple:
Open a checking and savings account. Maintain your checking account by keeping enough money in it to cover all outstanding checks. Make regular deposits in your savings account to establish a history of savings.
Apply for credit gradually — once your checking and savings accounts are in good working order and if you believe your budget can handle the financial load — through retail store credit cards, a major bank credit card or a gasoline credit card.
Don’t apply for more credit than you can manage. A credit card establishes you with credit as soon as your application has been approved.
Make regular payments for the products or services you purchase with credit. Every time you make a payment as agreed to a creditor, you are building a favorable credit history. If you consistently repay your debts, your positive credit history will build.
When to use credit
Use credit sparingly and effectively. First, determine how much credit you can comfortably afford — 15 percent to 20 percent of your take-home pay is a good rule of thumb. Develop a household budget — a detailed list of your income and expenses. If you find that you cannot afford credit purchases, considering your current income and expenses, you should still concentrate on establishing good credit, but continue making most of your purchases using cash.
Credit purchases should generally be limited to those that can be paid off at the end of the month. Larger purchases should be evaluated based on need, a usable life and a payment schedule established to assure that the debt is paid off quickly.
Here are a few more guidelines for using credit:
When you are building equity. A mortgage is a good example of using debt to build equity. Most people could not afford to buy a home by paying cash. Yet a home is often the largest and most important investment many people will make, and the profits they realize after the house has appreciated may likely far exceed the amount of interest they paid to purchase it.
When the interest is tax deductible. Borrowing may make sense in this case. Mortgages and home equity loans remain two of the last types of tax-deductible consumer loans.
To take advantage of sales. But ask yourself the following questions before you purchase a sale item with a credit card: Do you really need it? Will the amount of interest you pay on the amount you charge plus the sale price still be significantly less than if you paid full price for the item with cash?
When you are financing a business or venture. Few people who start businesses have the financial means to begin without borrowing. In many cases, they find the convenience of using credit cards preferable to begging their banker for loans.
To shop by mail. Sending cash or a check to an out-of-town company you’ve never dealt with before can be dangerous. If you pay by credit card, you are protected under the Fair Credit Billing Act if your order turns out to be different than what you specified.
• Aaron Ely is a senior mortgage banker from Ahwatukee. Reach him at (480) 636-6207 or firstname.lastname@example.org.