Four Common Forms of Credit
It is no wonder why borrowing money from someone is typical nowadays, it is because of the cost of living which absolutely get higher as time goes by.
Everyone wants assurance and guarantee when it comes with money. Because sometimes the comfortable you borrow money from someone or from bank companies, the harder you can pay it back until it reaches a high interest.
In that way, you are only causing trouble in your own life, and you are just making things difficult for yourself. Borrowing money from someone takes trust and patience.
As a lender, you need to trust the borrower that he or she will pay off the incurred debt at an agreed time. As a borrower, you need to settle your debt based on the agreement you and the lender have agreed.
Credit is a critical aspect of buying a home. A lender wants to make sure that a borrower will pay back the money. To determine that an individual is a good credit risk, a lender looks at four things, it is called the four C’s of credit – capital, capacity, credit history, and collateral.
Credit can be broken down in a couple of ways. One way is the amount of money you are approved to borrow from a lending institution. With this approval amount comes an agreement to repay. You’ll have charges to pay, and any additional fees that can or will be applied.
Credit can be classified as your borrowing reputation. It paints a realistic picture of your payment history and provides underwriters with proper information regarding the likelihood of your repayment.
Your credit is more than just a card sitting in your wallet. Credit cards can play a significant role in building and establishing your financial record.
Having a credit line extended to you means a bank believes you will give back the money you are borrowing to make a purchase. Lenders, in return, are paid interest as a percentage of your loan. Think of the interest you pay as paying for access to the credit.
Creating an accurate record of on-time payments can help you get lower interest rates. Particularly, when you finance a house, a car, a college education or smaller purchases such as new appliances.
A good credit score can have outstanding benefits. Like getting an apartment, signing up for utilities and even landing a job can all be affected by your credit history.
Landlords, utility companies and your potential employers may use your credit to figure out if you will be a responsible tenant, customer or employee.
If you develop bad credit history by making late payments or missing payments altogether, banks and other lenders will view you as a high risk. To protect their investment, they might charge you higher interest or not extend credit to you at all.
Make the absolute most out of your credit. Learn and understand your credit score and report. The sooner you can show discipline in your spending and keep careful control of your debt, the sooner you’ll have good credit.
The Four C’s of Credit
It refers to the amount of cash you have available is your capital. The more money you have in your savings account, bonds, certificates of deposit, IRA, or 401K.
Any other places where you have access to money quickly make a lender more comfortable. It will also show that you can cope with the financial emergencies that may occur after you move into your newly bought home.
If you have saved a capital, it shows the lender that you are able to manage and budget your own money. Lenders for home mortgages will ask how much money you have access to and where it came from.
This is an often called verification of deposit or income. You are required to show proof that you have enough capital to pay a down payment, loan fees, closing costs, escrow, and inspections.
Advance payments like those for property taxes, insurance, and moving expenses, lenders want to see that you have saved this money. They do, however, realize that this is difficult for low-income buyers. There are some loan programs which allow you to use your own savings money you received as a gift.
Your ability to make enough income to get the new mortgage is vital. You’ll need to make your loan payments and still pay all of your other living expenses is called your size.
Lenders want to see your ability to repay what you borrow. Lenders often calculate your capacity by looking at your current income, your income history and the amount you owe in debts.
The lenders need to see that you and your spouse, if you are married, currently make enough to pay your new house payment and any other expenses – such as taxes and insurances, and still live comfortably.
A lender might be looking at your gross income, which is the amount you earn before taxes. This will include commissions, overtime pay, dividends and any other money that is a part of your regular paycheck.
Lenders may look at your employment history and your future earning potential. The lender will also ask if you can show that you already have held steady jobs and made a stable income for the past two years, how long have you kept your current position?
Is it likely that you will keep earning at your current rate of pay or better for the next two years? The lender will also ask you questions in connection with the verification of income & employment.
A lender may contact your past and current employers to verify how much amount of money you earn, and you are likely to continue working there for the next two years.
The amount you owe – A lender will look at all your current debts, such as monthly payments, charge cards, child support, etc.
Keep in mind, lenders don’t include certain types of monthly bills, such as telephone, utility bills, auto insurance, life insurance, retirement, and savings contributions.
A lender wants to predict whether or not you will repay your debt accurately. A good indicator is how you have been with your prior obligations. If you have always re-paid the money you have borrowed on time, they will extend credit to you.
If you generally make cash purchases and use credit for larger purchases, emergencies, you are probably a good risk. But, if you have many loans, lines of credit, and credit cards but struggle to meet the minimum payments that are a bad sign. You may need to improve your creditworthiness before you apply for a mortgage loan.
A lender wants you to order a copy of your current credit report to learn about your credit history. Some people do not have a credit history because they have never used credit and they’ve never borrowed money. Even if you don’t have traditional credit, you may be able to get a loan for a home purchase.
Your property will be collateral or extra security for your loan. This is called a property lien. Did you know that you can use assets like a vehicle as collateral? Your lender will look at the value and condition of the asset. They want to make sure it is worth as much money as you are borrowing.
They also want to be sure that the house does not have any major repair problems that could potentially cost more money than you anticipated. Lenders determine value by hiring an appraiser. You may be asked to hire your own appraiser.
The appraiser uses his or her expertise to estimate the fair market value of a property. Every lender wants you to have “skin in the game.” This means that they want you to invest some of your own money. Banks will generally lend less than the fair market value.
The appraisal helps calculate the loan-to-value ratio, which helps lenders determine how much to lend and tells you how much of a down payment you will need. Lenders review the appraisal not just for value but also to make sure the house is in acceptable condition.
If the assessment shows that any significant parts of the house are not in good shape, the lender may agree to make the loan only if the element is fixed. This is called property condition contingency. It is a protection for you as well as the lenders.
Now that you already have the knowledge about what is a credit and its importance as well as the four Cs of credit, you also need to know what are the common types of credit.
There are three general categories of credit accounts that can impact your credit scores – these are revolving, open and installment.
Although having a variety of credit types can be useful to your credit health, it is not the most crucial factor in determining your score.
Your credit scores can make you feel a lot like grades in the school – and they kind of are.
Creditors use credit scores as a tool to assess your creditworthiness — i.e., whether you’re likely to pay credit issuers back if they give you money.
According to one of the significant credit-scoring modelers – which is FICO, credit scores are made up of five factors. (1) Payment history – 35% (2) Amount of debt owed – 30% (3) Age of credit history – 15% (4) New lines of credit – 10% (5) Credit mix – 10%
Revolving credit lines are one of the most common types of credit accounts. Revolving credit is a line of credit that you can borrow from freely but that has a cap, known as a credit limit.
This cap represents how much can be used at any given time. It typically refers to credit cards and home equity lines of credit (HELOCs). And it usually requires monthly payments and interest charges if you carry a balance.
If you have a revolving account, the creditor has approved you for a set amount. That fixed amount represents your credit limit. You can access your credit line whenever you want and as often as you like.
In return, you must pay the creditor a minimum amount on your account’s outstanding balance every month. Credit cards and home equity lines of credit are examples of revolving credit.
This form of credit allows you to spend up to a certain amount. The lender sets your credit limit, or the most you can use.
In revolving credit, the borrower rotates the balance by carrying it forward from month to month until it is paid in full. Interest charges typically occur for any revolving balance.
As the money is repaid, the difference between the maximum credit limit and the current balance is available to still be borrowed.
This is the most common form of a credit issued by credit cards, such as Visa, MasterCard, and store and gas cards. Credit cards are considered unsecured credit because there is no collateral securing the money borrowed.
This form of credit is often mistaken to be the same as a revolving credit card. However, the significant difference between a credit card and a charge card is the credit card can carry a balance, whereas the charge card must be paid in full each month.
If the balance is not paid on time and in full, penalty fees will be added.
American Express is an example of a well-known charge card. This form of credit is advantageous against accumulating credit card debt.
A charge card actually works as a type of credit card that requires you to pay your balance in full at the end of each billing cycle, rather than to make monthly minimum payments on the balance over several months.
Charge cards force you to be responsible with your spending because you have to pay your balance off at the end of each and every month. Charge cards also allow users to make purchases which can then be paid at a later time.
However, charge cardholders must pay back the entire amount they borrow each month upon the due date. If they fail to do so, they are subject to substantial fees and can even potentially lose their charge card.
One of the most critical features of charge cards is that they have no preset spending limit. This means that there is no hard limit placed on how much money a user can spend on credit, or “borrow” from their credit card company.
There are four main differences between charge cards and credit cards, and they are between their payment terms, spending limits, annual fees, and options available. Whether a charge card or a credit card is better for you depends on how confident you are in your ability to pay off your entire balance regularly.
Payments are due on time (or the flip side – whether you need external pressure to force yourself to be responsible with credit), how regular your spending habits are from month to month, and whether you’re okay with a limited choice you have to pay for each year. Charge cards are best for individuals who have the means to pay off their credit balance every month.
They are generally more expensive than most credit cards, but for that charge card holders enjoy some added benefits, such as having no preset spending limit, or access to American Express’s Membership Rewards program.
This last point allows charge card users to make big purchases, without having to worry about hitting the same limit month to month. Charge card issuers will generally work with the cardholder to allow the consumer to make purchases which the banks think can be paid back.
Another way of looking at this is: because charge cards have to be paid off in full each month or else assess penalty fees, some cardholders find this to be an excellent way to instill financial discipline and force themselves only to buy things on credit that they can reasonably pay off.
Because you do not have to pay off your balance each month, using a credit card has the potential to lead to some poor financial management. Charge cards train users to develop behavior that is conducive to good budget management.
Failure to pay off the balance due on a charge card has harsher consequences, however, that are seen with credit cards. Charge card users may see more damage done to a credit score and higher penalties for missing a payment, than if he or she had applied for a credit card instead.
Installment credit involves a set amount borrowed, a fixed monthly payment and a fixed timeframe of repayment.
Interest charges are pre-determined and calculated into the set monthly payments. Common forms of installment credit agreements are home mortgages and auto loans.
With installment credit, you borrow a certain amount of money for a set period of time, and you repay the money by making a series of fixed or installment payments. Examples of installment credit include mortgages, car loans, and student loans.
Installment credit is also typically secure. Secure credit requires security for the lender. The borrower must provide collateral, something of value pledge to guarantee loan repayment. If the borrower fails to repay or defaults on loan, the lender may confiscate the collateral.
A home is an example of insurance on a mortgage, and a vehicle on an auto loan. If the borrower were to default, the house or car would be repossessed.
Revolving credit is when a lender extends credit to you that remains the same amount month over month. You’re free to use as much or as little of that credit line as you wish on any purchase you might make with cash. At the end of each month, you’re sent a bill for the balance. If you don’t pay it off in full, you pay interest on the remainder.
Revolving credit can help you manage expenses before your next paycheck arrives. Plus, using rewards credit cards on purchases you have to make anyway is a great way to put money back in your pocket. Just make sure you’re doing it right:
• Keep balances low. With a credit card or other types of credit, you’re able to use up to 100 percent of the credit extended to you. But that doesn’t mean you should. Maxing out your credit will lower your credit score. Keep balances low throughout the month – ideally, under 30 percent utilization – to ensure you maintain healthy credit utilization ratio.
• Pay off balances every month. A first-time late payment on your credit card can result in a fee as high as $27. Plus, some issuers will raise your annual percentage rate on future purchases as a penalty. The worst consequence, however, is a potentially severe drop in your credit score. Staying on top of your bills is the safest thing you can do to maintain good credit.
• Avoid too many applications for revolving credit. Before applying for a credit card or other type of credit, be sure your credit score is in good shape to avoid being rejected. And if you are approved, space out future applications to avoid a ding to your credit score.
Revolving credit can be a useful tool or a drag on your credit score, depending on how you use it.
If you’re a responsible spender and pay your bills on time, you should be able to use credit to your advantage while also building a good credit score. Now that’s a win-win.
Non-Installment and Service Credit
This form of credit allows the borrower to pay for a service, membership, etc. at a later date.
Generally, payment is due the month following the service, and unpaid balances will incur a fee, interest, and/or penalty charges. Continued non-payment will result in service cancellation and can be reported to the credit bureau, affecting your credit score.
Service or non-installment agreements are widespread in our everyday life. Cell phone, gas, and electricity, water and garbage are all examples of service credit. A non-installment credit is a kind of credit which is paid in lump sum and not through installments.
It is the most straightforward form of credit which an individual may acquire. It may be unsecured or secured with any personal or real property of the borrower.
It is usually payable in a short period of time and failure to settle the obligation within the said period may lead to penalties and interest charges. There are two kinds of non-installment credit – the secured one and unsecured.
A secured credit card is often recommended for consumers who have trouble getting a traditional credit card – consumers who haven’t yet established a credit history or who have damaged credit.
A secured credit card is very much like a regular credit card, but the significant difference is that you’re required to make a deposit against the card’s credit limit. Your credit limit will usually be a percentage of your security deposit, or it may be the same as your deposit.
Many banks place your deposit into an interest-bearing savings account where it stays until you close your account, upgrade to an unsecured credit card or default on your credit card balance.
Unsecured credit cards are the most common type of credit cards. They are not secured by collateral. That means that unlike secured loans, such as mortgages or auto loans, unsecured credit cards are not directly connected to property that a lender can seize of the cardholder fails to pay. Unsecured credit cards are the most common type of credit cards.
They are not secured by collateral. That means that unlike secured loans, such as mortgages or auto loans, unsecured credit cards are not directly connected to property that a lender can seize of the cardholder fails to pay. Issuers of unsecured cards must make use of other means – such as the courts or garnishment – to collect unpaid debts. Customers qualify for unsecured cards based on their credit history, their financial strength, and their earnings potential.
Keeping your debt levels low (especially credit card debt) and paying off your accounts on time are essential steps you can take to help your credit scores. Having a healthy mix of credit, such as revolving and installment credit, can also improve your credit scores.
Staying on top of your payments regardless of credit type can help show lenders that you can responsibly handle various types of credit. A credit card can make impulse buying easy, but be careful you don’t overdo it. Try to pay as much off your balance each month as you can and don’t just pay the minimum. This will reduce how much interest you pay.
I hope that this article clearly explains and helps you understand the four common types of credit and differences. Always remember that only charge products or services that you only afford to pay when the due date comes.
There are more types of credit that we have not covered here. We haven’t touched on corporate credit, vendor credit, or store credit cards. These credit lines can come in handy when you shop at a certain store very often.