💰Personal Financial Management Unit 6 – Consumer Credit & Credit Scores

What's Consumer Credit?

• Consumer credit refers to the ability to borrow money or access goods and services with the agreement to pay later
• Allows individuals to purchase items they may not have the immediate funds for (vehicles, homes, education)
• Lenders extend credit based on the borrower's creditworthiness and ability to repay the debt
• Creditworthiness is determined by factors such as income, debt-to-income ratio, and credit history
• Two main types of consumer credit: revolving credit (credit cards) and installment credit (loans)
• Interest is charged on borrowed funds, which is how lenders profit from extending credit
• Responsible use of credit can help build a positive credit history and improve financial opportunities

Types of Credit

• Revolving credit allows borrowers to access funds up to a predetermined credit limit (credit cards)
  • Credit limit is the maximum amount that can be borrowed at any given time
  • Balances can be carried over from month to month, with interest charged on the outstanding balance
• Installment credit involves borrowing a fixed amount and repaying it in regular payments over a set period (auto loans, mortgages, student loans)
  • Payments include a portion of the principal and interest
  • Interest rates can be fixed or variable, depending on the type of loan and lender
• Secured credit requires collateral, such as a car or house, which the lender can seize if the borrower defaults
• Unsecured credit does not require collateral and is based on the borrower's creditworthiness (personal loans, credit cards)
• Open credit allows borrowers to make purchases with no preset spending limit (charge cards)
  • Balances must be paid in full each month to avoid penalties and maintain the account in good standing
• Service credit involves ongoing services (utilities, cell phone plans) billed and paid monthly

Understanding Credit Scores

• A credit score is a numerical representation of an individual's creditworthiness
• Scores typically range from 300 to 850, with higher scores indicating lower credit risk
• The most widely used credit scoring model is the FICO score, developed by Fair Isaac Corporation
  • FICO scores are used by 90% of top lenders when making credit decisions
• Credit scores are calculated using information from an individual's credit report
  • Credit reports contain data on credit accounts, payment history, and public records (bankruptcies, liens)
• Lenders use credit scores to assess the risk of lending money or extending credit to an individual
• Higher credit scores often result in better loan terms, lower interest rates, and easier access to credit
• Maintaining a good credit score is crucial for financial well-being and future borrowing opportunities

Factors Affecting Your Credit Score

• Payment history is the most significant factor, accounting for 35% of a FICO score
  • Late or missed payments can significantly lower a credit score
  • Consistently making payments on time helps maintain a good credit score
• Credit utilization, or the amount of available credit being used, accounts for 30% of a FICO score
  • High credit utilization (using a large portion of available credit) can negatively impact a score
  • Keeping credit utilization below 30% is generally recommended
• Length of credit history makes up 15% of a FICO score
  • A longer history of responsible credit use positively impacts a score
  • Closing old accounts can shorten credit history and potentially lower a score
• Credit mix, or the types of credit accounts held, accounts for 10% of a FICO score
  • Having a diverse mix of credit (revolving, installment) can positively impact a score
• New credit inquiries make up 10% of a FICO score
  • Applying for multiple new credit accounts in a short period can temporarily lower a score
  • "Soft" inquiries, such as checking one's own credit, do not affect a score

Building and Maintaining Good Credit

• Establish credit early by opening a credit card or becoming an authorized user on someone else's account
• Always make payments on time, as payment history is the most critical factor in credit scores
• Keep credit utilization low by using only a small portion of available credit and paying balances in full
• Maintain a mix of different types of credit (revolving, installment) to demonstrate responsible credit management
• Avoid applying for multiple new credit accounts in a short period, as this can lower credit scores
• Regularly review credit reports for errors or signs of identity theft, and dispute any inaccuracies
• Consider using automatic payments or calendar reminders to ensure on-time payments
• Gradually increase credit limits over time to lower credit utilization and improve credit scores

Common Credit Pitfalls

• Maxing out credit cards or consistently maintaining high balances can lower credit scores
• Missing payments or making late payments can significantly damage credit scores
• Closing old credit accounts can shorten credit history and increase credit utilization, potentially lowering scores
• Applying for multiple new credit accounts in a short period can result in numerous hard inquiries and lower scores
• Co-signing for someone else's loan or credit card can put you at risk if they fail to make payments
• Falling victim to identity theft can result in fraudulent accounts and damage to credit scores
• Ignoring credit reports or failing to dispute errors can allow inaccuracies to persist and harm credit scores
• Using cash advances or making only minimum payments on credit cards can lead to high-interest debt

Credit Reports and Monitoring

• Credit reports are detailed records of an individual's credit history, including account information and payment history
• The three main credit bureaus in the United States are Equifax, Experian, and TransUnion
  • Each bureau maintains its own credit report, which may contain slightly different information
• Consumers are entitled to one free credit report from each bureau annually through AnnualCreditReport.com
• Regularly reviewing credit reports helps identify errors, signs of identity theft, and areas for improvement
• Credit monitoring services alert individuals to changes in their credit reports (new accounts, inquiries)
  • These services can be helpful for early detection of identity theft or fraudulent activity
• Disputing errors on credit reports involves contacting the relevant credit bureau and providing evidence of the inaccuracy
• Lenders and creditors report account information to credit bureaus, which is how credit reports are updated

Impact of Credit on Personal Finance

• Credit scores influence the ability to obtain loans, credit cards, and other financial products
• Higher credit scores often result in better loan terms, lower interest rates, and reduced borrowing costs
• Poor credit can lead to higher interest rates, difficulty obtaining credit, and limited financial opportunities
• Employers may check credit reports as part of the hiring process, particularly for positions involving financial responsibility
• Landlords often use credit reports and scores to screen potential tenants and assess their financial reliability
• Insurance companies may use credit-based insurance scores to determine premiums for auto and homeowners insurance
• Maintaining good credit is essential for achieving long-term financial goals (purchasing a home, starting a business, saving for retirement)
• Regularly monitoring credit reports and scores helps individuals stay informed and make proactive financial decisions