Credit Score vs. Rating: Is Your Credit Healthy?
I’ve come down hard on credit before, but it’s actually an incredibly useful tool if used correctly. With credit, you can make purchases that were otherwise unavailable (like an investment home), it can be an effective tool to manage your monthly cash flow, and when used in finance, you can make larger real gains (because the debt is fixed, but your overall earnings are larger. Those are the good things about credit.
Credit can also ruin your life. Credit, by its definition, means using money you don’t have. It does have to be paid back. By overextending yourself and having too much debt, you put yourself at a huge risk to not be able to pay it back and be forced into bankruptcy. That’s essentially what happened to Lehman Brothers and Bear Stearns during the 2008 Financial Crisis and what happens to countless consumers through credit cards.
In order to get credit, you must qualify for credit. Sadly, credit is not gifted to you by a Credit Fairy who comes in at night and leaves you a shiny, plastic card under your pillow if she likes you. It’s given by banks or other various lenders who go through a risk determination process called underwriting where they decide if 1. You qualify and 2. What their premium (read: interest rate) will be.
Credit or No Credit Score
So let’s say you decide you need to open a credit line, perhaps for a new home or car. The first thing you’ll want to do is look at your personal budget – check out this article about how to plan your budget. Make sure you can afford the monthly cash payments based what the expected interest rate is and how much you’ll need to finance. Bankrate.com has excellent calculators for this task, as well as a lot of posted rates for various loans to do your research. If the cash payments still keep you within budget, the next thing you’ll need to do is get a pre-approval to make sure you can get financing.
To get the pre-approval, the bank will likely get a credit score for you. It might be a FICO, it might be a Vanguard or Experian or one of the other six or seven places to get a score. And once the bank decides where they’re going to get the score, they then have to decide which score to use. As in, each of the places that give a score have seven or eight different variations. It’s a highly inefficient and outdated process, but it’s still a requirement. You can kind of think of the credit score kind of like a thermometer. It does provide useful information – kind of a temperature of your financial health – but it doesn’t tell you what’s wrong with you or what symptoms you may have. When tracking your own credit score it only matters for two things. The first is whether or not you might qualify for credit. A higher score is a better score and the more likely you will get the loan. A lot of banks and programs have minimums they require before they will even to talk to you. The second is the higher your score the more favorable rates you will get. The interest rate is a risk premium for the bank. If you’re less likely to default, you’ll get a lower rate. What all that boils down to for you, the consumer, is if the national rate says it’s around 3.5% and your score is a 640, you should probably round up when figuring out what the loan is going to cost you on a monthly basis.
The Credit Rating
The next step in the process after you’ve got a pre-approval and found the actual product you want to finance, is to actually get the loan. This is where the underwriting comes in. The bigger the purchase the more in-depth the process is. The bank will ask for payment stubs, credit card statements, student loans, and pretty much anything else that will factor into your ability to pay back the loan. If your income varies widely from month to month and year to year, they’ll likely take an average and then apply a discount rate to factor for variance. For instance, if you own rental property, they will probably apply a 25% discount rate to your yearly rent premiums to account for vacancy; and they’ll do so regardless of whether or not you have had a vacancy recently or not. This is because on average, most rentals are empty for three months out of the year. For freelancers or contractors that can pose a serious problem when qualifying for a loan. For those types of jobs, it’s probably smarter to have a larger pool of cash laying around to show you have reserves to buffer any shortcomings in your month to month income.
So the bank takes all of this information, compiles it, and then runs it through their software. What they’re looking to do is formulate a credit rating for the debtor. This isn’t a quantifiable number that you can use to negotiate better terms with another bank, but it’s just a more wholesome view of your current financial situation. The most important takeaway of the credit rating is that it directly impacts the amount of money you qualify for and how much you’re going to pay for it in interest!
The credit score is a quick read of your credit worthiness. It lets you know if you are likely to pay more on a loan in interest than other people, but it isn’t a great indication of your overall financial health. Someone who is overleveraged already, but pays their bills on time could have a great score. The credit rating is a more complete look at someone’s financial health and their ability to repay loans. It’s a factor of income, savings, retirement, debt, and stability and provides the banks much more information; however, it’s costlier to do and thus only done at the end of a loan process.
The credit score and credit rating are different tools that are useful at different points in the loan process. However, by doing monthly budget checks and keeping a note of your financial health, you shouldn’t face any nasty surprises. If you would like to see my experience in starting the loan process with buying a house, check it out here.
Readers, what sort of experience have you had with banks when it comes to getting credit? What sort of things have you helped you when it came to getting a loan? As always, be sure to like my Facebook page to get all the newest updates, and share the article with your friends. Let them know you’re on the road to conquering your financial empire!