How Credit Works

Here’s “what we should have learned in school” about credit.  Without this information, you’ve probably wasted thousands of dollars, or worse.  Now you’re about to learn exactly how your creditors have been taking advantage of you this whole time, and how to flip the tables to win the credit game.  This unique info is unlike anything else out there in it’s completeness, effectiveness and simplicity.  Please enjoy the benefits forevermore…

I’d like to give you my world famous “three-legged stool” analogy to help you forever understand credit easily.

There’s a lot of information out there about credit. You can get into a lot of complexities, but this little analogy is going to make it very simple to see where you’re at now, and how each different option will affect you – no matter what you do.

So imagine, if you will, a three legged stool…

And on this stool are these three legs because your credit is really made up of three main factors:

The first leg is your payment history. Your payment history is whether you pay your payments on time, if you have any past due accounts or this kind of thing.

Second leg on the stool is your debt-to-income ratio. That is how much debt service you pay, what you are obligated to pay each month towards debt verses your gross income each month.

The third leg on the stool is your debt-to-credit-limit ratio or “utilization”. How much your current balances are compared to your credit limits.

Next we are going to look closer at each “leg” of this three-legged stool individually, so you can gain more insight into how credit works.

So let’s take a look at each of these three legs, starting with the first leg…

First Leg: Payment History

If credit is like a three-legged stool, then the first leg of your credit is your “payment history.”

Payment history is simply a record of how well you’ve made your payments; if you’ve been on time or if you’ve ever been late. Payment history is the most common factor people think of in regards to keeping or maintaining their credit. It is important, but it’s only 30-35% of your score, “about a third”.

There are two characteristics of your payment history you need to know:

The first characteristic of your payment history is that “time is your friend”. This works both ways, for good credit and bad credit. The longer you’ve had a good payment history, the better it is for your credit. Thus, an account in good standing for several years will help your credit more than a new account with minimal history. While most negative marks such as late payments will remain on your credit report for seven years, their affect on your credit score will lessen over time, because, “time is your friend”. Late payments in the past few months are going to be much more severe than from a few years ago. As time goes by these negative items will affect you less and less until they drop off of your report at the end of seven years.

The second characteristic of payment history is IF you have never missed a payment and have a “perfect payment history”, then you’re in great shape. You have something to lose in this area of your credit and should keep this in mind.

However, the unfortunate reality seems to be that missing even one payment by 30 days knocks your credit score right out of the sky. It’s as if the very first negative item on a credit report knocks the wind right out of your sails. My clients report a drop of 100 points or more after missing a single payment.

The first late payment has the most severe negative affect on your credit. Once you’ve taken this initial hit, most of the damage is done. Additional late payments seem to have less and less of a negative effect, meaning the more negative items you get, the less of a negative affect they each have because most of the damage is done by the very first ding.

It makes sense when you realize lenders are in the business of making money by charging interest. The higher the interest they charge, the more money they make (as long as the debt is repaid). So they’re quick to justify charging higher interest as soon as you give them any reason to do so.

Keep these characteristics of payment history in mind as we go through your options to get out of debt.

Shattering a common MYTH

A lot of times people ask, “If I get a bad payment history, will it ruin my credit forever?”

No, that’s not true at all. Having late payments, collection accounts, charge offs, etc will not ruin your credit forever.

Take a look at folks who have filed bankruptcy in the past few years. Until October 2005, when the laws changed, record numbers of people were filing bankruptcy every year. In fact, more people filed bankruptcy in 2003-2005 than any other time in history, including during the great depression. So there’s a lot of people out there who filed bankruptcy in the past five years or so.

What’s strange is that even though these folks filed bankruptcy (the ultimate financial failure sitting there on their credit report for the whole world to see, severely damaging their payment history), many are able to get new credit, home loans, car loans and low interest credit cards WITHIN JUST A YEAR OR TWO after filing bankruptcy. (Sometimes even from the same creditors they filed bankruptcy with!?!)

Why is that? How does that happen if they just filed bankruptcy?

One factor is that after filing for Chapter 7 bankruptcy, there’s a period of time (seven years) before a person can file again.

The biggest reason, however, is if someone doesn’t owe any more debt, then all of their money is freed up every month to pay for new credit. Even though their payment history may have taken a severe hit from a bankruptcy, they can still get new credit because payment history is not the whole picture… there’s more to the credit puzzle!

Of course, less severe negative credit entries such as late payments, collections and charge-offs accounts are not nearly as bad a bankruptcy once the debts show a zero balance.

So even if you already have a bad payment history don’t despair, because it isn’t going to ruin your credit forever. Staying in debt is the real problem. There are a couple other credit factors you may be able to do something about to get back on track quickly.

After we finish looking at the three legged stool we’ll also look at how to repair a damaged payment history and how to rebuild a new good payment history. But first you need to know the other two-thirds of the puzzle.

So that’s “payment history”, the first leg on this three-legged stool. Again, a very important factor but it’s not everything because payment history only makes up about one-third of your credit score or credit “worthiness”.

Now let’s look at the rest of the story – the other two-thirds of the credit puzzle…

Second Leg: Debt-To-Income Ratio

The second leg of my World-Famous “Three-Legged Stool” Analogy of “How Credit Works” is your “debt-to-income ratio”.

“DTI” as they call in the mortgage industry.

If you’ve ever gotten a mortgage or refinanced your home, then you know the mortgage folks are very interested in your debt-to-income ratio.

Remember, debt-to-income ratio is the amount of money that you’re obligated to pay each month towards your debt vs. your monthly income, but what’s important is how the creditors see it…

To calculate your debt-to-income ratio, just follow these three simple steps:

Step 1. Add up your total monthly gross income.

That could include your income from an employer, bonuses, tips, commissions, government benefits, child support, alimony and interest and dividends accruals.

Step 2. Add up your total monthly debt payments.

Needless to say, that includes your mortgage payments, your car payments and any minimum payments you make on your credit cards. It does NOT include your taxes or utilities.

Step 3. Divide your debt payments by your monthly income.

Here’s the formula:

Total Monthly Debt Payments ÷ Monthly Gross Income = Debt-to-Income Ratio

Sample debt-to-income table based on a person earning a gross income of $66,000 per year:

Step 1. Add up your total monthly gross income.

Monthly Income (Gross)* = $5,500

* Monthly Gross Income: Income before taxes and other deductions

Step 2. Add up your total monthly debt payments.

Debt / Monthly Payments:

Mortgage Loan $1,300/mo

Auto Loan $395/mo

Credit Card #1 $60/mo

Credit Card #2 $45/mo

Credit Card #3 $75/mo

Total Monthly Debt Payments = $1,875

Step 3. Divide your debt payments by your monthly income.

$1,875 ÷ $5,500 = .34 (34%)

This person has a debt-to-income ratio of 34 percent.

According to most lenders, a debt-to-income ratio of 36 percent or less is what you should aim for. It’s an indication to lenders that you have disciplined spending habits and are “credit worthy”.

Here are the other percentage categories most lenders recognize:

37 to 42 percent: Your debts appear manageable, but are more likely to get out of control. Start paying them down now. You may still be able to obtain credit cards, but acquiring loans may prove difficult and will cost more.

43 to 49 percent: Your debt ratio is too high. Financial difficulties are likely unless you take immediate action. You may still obtain financing, but at much higher rates, costing you far more money over time.

50 percent or more: Seek professional help immediately to reduce debt before it’s too late.

Important: Recalculate your ratio every year or whenever you face a significant life event, such as divorce, job change, etc.

So now you know if you’re on sound financial footing or if your ship is likely to sink. (You probably had a good guess anyway, but the Debt-to-Income Ratio confirms it.)

Another way to look at this is, how much money do you have available to pay for new debt? How much more in monthly minimum payments can you afford? Lenders still want to lend you as much as they can within a tolerable risk, but they charge you much more interest to do it.

If you have past due amounts, then this is for you:

If you’re reading this, then it’s very likely you’re experiencing some kind of financial hardship; whether it’s medical issues, unexpected bills, loss of a job or reduced income, even poor money management. These are the most common things getting people into deep trouble.

Here’s a “secret” you need to know about how being past-due may be affecting your debt-to-income ratio:

Say you fell behind a couple of months and there’s a past due amount listed on your credit card account statement. When computers scan your credit report, they’re looking for the current amount due, this goes up to include all past due amounts and “lop-sides” your debt-to-income ratio, making it go through the ceiling.

Often when people lose a job or have a reduction in income, they fall behind on payments… and those stack up as past due amounts… and this exponentially worsens their debt-to-income ratio. (Quadruple whammy – Ouch!)

If you’re in hardship situation like this, then it’s time to “do something” to eliminate your debt, ASAP!

Your debt-to-income ratio reveals your financial soundness. Monitoring your ratio also helps to avoid “creeping indebtedness.” If you’re seeking to obtain a loan for a home, vehicle or business, lenders look at this ratio when they’re considering extending a line of credit.

A Credit “Secret” Most People Will Never Know:

You can have a perfect payment history (never missing a single payment), but if your debt-to-income ratio is too high then you’re effectively crippled when it comes to “credit worthiness” (your ability to get a loan). You’re not credit “worthy”, even though you may have a good credit “rating”.

So that’s your “debt-to-income ratio” – a very important factor of your credit.

How’s the second leg of your three-legged stool looking right now?

Where is your debt-to-income ratio?

Good, bad or crippled?

Write it down in your workbook!

Third Leg: Debt-To-Credit-Limit Ratio (Utilization)

Welcome to the third and final piece of the credit puzzle…

You’re just about to completely understand “How Credit Works” and gain an exact understanding of where your credit is right now.  This will help you make your best choice to be debt free ASAP by understanding how each option to get out of debt will affect your credit, now and in the future.

The third and final leg on this three-legged stool is called “utilization,” or your “debt-to-credit-limit ratio.”

This is probably the least known and most misunderstood factor affecting your credit.  The way this works is very interesting. Basically, each account you have has a credit limit and a current balance. The use or “utilization” of your available credit affects your credit rating and credit worthiness for EACH account you have, as well as all of your credit accounts combined.

Here’s how it works:

• BEST = The “sweet spot” is keeping your balances at 20-25% of their limit.  Paying off your balances every month will actually hurt you.  Credit card companies refer to you as a “deadbeat” because you are basically using their money for free without paying them interest.  This is great for you,  (highly recommended over paying interest, if you can manage it) but not good for the creditor.  Their ideal customer is the one paying the most interest, and since they make their money charging you interest, they penalize you for keeping your balances at 0%.  To get the best credit rating without triggering any negative effects (especially to build or rebuild your credit), charge your cards up under 50% of the balance and pay them down to 20-25% each month.
  *Source: PBS Frontline/NY Times Special Report “Secret History of the Credit Card”
  
• GOOD = If you have an account with a current balance less than 50% of it’s credit limit, then that’s a positive factor for your credit.
• BAD = If you have an account that’s over 50% utilized (meaning the current balance is over 50% of the credit limit), then it becomes a negative factor for your credit.  It becomes more severely negative if the current balance goes over 75% of the credit limit.
• CRIPPLED = If you have an account that’s “maxed out” (100% utilized – the current balance is at the credit limit), especially if it’s “over the limit” (the current balance EXCEEDS the credit limit) your “debt-to-credit-limit ratio” is effectively crippling your credit and credit worthiness.

Again, you can have a perfect payment history, you may have always made your payments on time or early, but if you’ve got an over the limit account then you’re going to be stuck.  Having a BAD or CRIPPLED “third leg” can trigger “universal default” causing your interest rates to jump to 20-30% or more, even on other accounts with low balances.  It’s just another sneaky trick the credit card companies are playing on you.  Here’s a video of President Obama addressing this very issue of consumer abuse by credit card companies: CNN – Obama Addresses Credit Crunch

You should always look at your utilization before applying for any major financing like a new home loan, a mortgage refinance or buying an automobile. A bad or crippled debt-to-credit-limit ratio can hurt you, resulting in much higher fees, payments, finance charges and interest costs.

Tip to Quickly Improve Your Debt-to-Credit-Limit Ratio

Perhaps you’re one of the people that are concerned about a mortgage going to an adjustable rate, or this conversion already happened and you’re paying too much for your mortgage.  You need to refinance. Your debt-to-credit-limit ratio is going to be a big issue for you very quickly. One quick trick that might work you is this: Simply call and ask the creditor to increase the limit, if they can increase that limit to twice or more of your current balance you’ve effectively improved that area of your credit! It will go from a negative to a positive right away.

Keep your debt-to-credit-limit ratio in mind because the credit bureaus weigh heavily on it.

Obviously, if you’ve got a card that’s maxed out, like most Americans, it has a negative effect on your credit. How can you fix that? The most basic way is to pay it down below 50%, and that negative factor will go away.  We’ll also talk about certain debt relief programs that can wipe out your debt balances for you very quickly, which impacts your debt-to-credit-limit ratio in a very positive way.

Do you understand how Debt-To-Credit-Limit Ratio (Utilization) works now?

How is YOUR Debt-To-Credit-Limit Ratio RIGHT NOW?

• Good ? (All debt balances are less than 50% of their credit limits.  Remember, the “sweet spot” is 20-25%)
• Bad? (At least one debt balance is over 50% of it’s credit limits.  Remember, it only takes one account “over-utilized” to negatively impact your credit)
• Crippled? (At least one debt balance is at 100% of it’s credit limit (MAXED-OUT), OR OVER THE LIMIT.  Remember, it only takes one account “over limit” to cripple your credit)

So that’s the World Famous “Three-Legged Stool” Analogy of “How Credit Works”:

1. Payment History
2. Debt to Income Ratio (DTI)
3. Utilization (Debt to Credit Limit Ratio)

At this point, make a mental note of how your credit is right now…

How is YOUR Credit Right Now OVERALL?

A) All THREE GOOD legs?

B) TWO GOOD legs and ONE BAD leg?

C) ONE GOOD leg and TWO BAD legs?

D) All THREE BAD Legs?

To understand consequences to your credit for each option, we must first understand “How Credit Works” and how our credit is right now. All set?

Keep in mind “How Credit Works” and where your credit really is right now as you learn your different options for getting out of debt.  I will relate to this three-legged stool analogy throughout this financial educational program so you’ll understand how each option will specifically affect you in your unique situation.

But Wait, There’s More…

There’s one more catch to understanding just how credit works…

Credit “Rating” (Score) vs. Your Credit “Worthiness”

I understand you’re concerned about your credit, especially if you currently have a high credit score, and you should be.  That’s smart, but do you really understand the difference between your credit “rating” (score) vs. your credit “worthiness”?

Not many really do.

Let’s take a look at this critically important distinction…

>>> NEXT: Credit “Rating” vs. Credit “Worthiness”

Here To Be An Asset To You,

Jesse Niesen
DebtGoToGuy.com