Managing Director Marilyn F. Booker outlines the responsibilities of building and maintaining your creditworthiness.
My personal finance teachings around the country always include a rich discussion about credit and debt. I’m asked a number of questions, often starting with, “what actually is credit?”
Credit is defined as trustworthiness, or the confidence in a purchaser’s ability and intention to pay. A measure of this is your credit score, a numerical calculation of the likelihood that you will not make your payments or default on your loan. This score is based on a number of factors, including your history of making timely payments, how many credit accounts you’ve had or now have open, and any claims against you for defaulting on these obligations.
A low score could mean you are considered a high risk and that lenders, such as banks and credit card companies, may be reluctant to extend you credit (in the form of a loan or a credit card). A high score, however, could mean you are considered a low risk and will likely repay a loan or credit card balance and do so on time.
Having good credit makes conducting basic financial transactions convenient. It can be safer to carry a credit card instead of large amounts of cash, since, if lost or stolen, cash is difficult—if not impossible—to replace or have returned. On the other hand, if a credit card is lost or stolen, you can simply call the issuing company to cancel the card, and you will not be responsible for unauthorized charges.
Good credit may also give you the option to purchase items you would rather pay for at a later date or over time. Most people do not buy large items such houses and cars, or finance major expenses such as college tuition, simply by writing a check. However, many make payments over time that include the interest charged by creditors for the privilege of borrowing. Without a decent credit score, no one is likely to lend you money, or creditors willing to take the risk of lending to you will likely charge interest rates so high that you end up paying many times the amount someone with good credit would have paid.
There are a few ways to find out your credit score. If you apply for credit and are denied, typically the communication denying you credit will include instructions on how to get a free copy of your credit report, including your credit score, upon which that denial was based. Federal law gives everyone the right to one free credit report from each of the three credit agencies– Experian, TransUnion and Equifax–every 12 months, but you have to request it, and they may charge a fee to include your credit score. You can also check any existing loan or credit card statements for your credit score. In addition, a number of credit card companies offer their customers free credit scores.
To improve your credit, the best course of action is to start building a positive credit history, or a record of borrowing money and paying it back. To start this journey, you have to have income. So establish a steady employment record, and pay all your bills on time. Having a checking account and maintaining a positive balance will also help your credit rating. You might consider applying for a few different credit cards and should pay those credit card bills on time. If you are in a position to use your savings account as collateral, consider opening a small loan to establish a history of making monthly payments on time. If you cannot get a loan in your name, secure a co-signer and pay that loan back as agreed might be an option. The theme here is simple – pay all debts back on time and early if possible, but never late.
Indeed, debt can be good or bad. Good debt, such as a mortgage or a car loan, goes a long way in establishing a solid credit history and generally has reasonable interest rates (rarely in the double digits). Bad debt typically is credit card debt that has an unusually high interest rate and requires small monthly payments. This may put you into a vicious cycle of paying quadruple the price of what was actually charged, and you end up paying interest on the interest on the interest. So never run up large credit card bills and only pay the minimum. Further, when your credit score is being calculated, high balances on credit cards are not always in your favor. A good rule of thumb is to pay off credit card bills within the same month you incur the charges, or no more than two months out.
A basic guideline is to use credit for items that appreciate, meaning you would be able to sell the item in the future at a profit. Cars depreciate, or lose value, once driven off the sales lot, but if pressed to sell down the road you would be able to. Use cash for small items that don’t appreciate, such as clothes, food and electronics. Or use a credit card to pay for such items only if you plan to pay the credit card bill in full when it arrives. For these types of purchases, you should have the cash in the bank or at home—perhaps just not in your pocket at the point of sale. Interest on these items can rack up quickly and balloon your outstanding credit balances.
Credit card debt, small loans and student loans generally should be prioritized and paid off first, starting with the debt with the highest interest rate. Long-term debts, such as mortgages (loans to purchase a home, usually 15 or 30 years) and car loans (typically five years), are often lower on the list since they can help you establish a record of paying debt consistently and on time. Plus, the interest you pay on mortgages might be tax deductible.
Ultimately, the best way to manage credit and debt is to be responsible. Here are some guidelines to adhere to:
- Borrow only what you can, and plan to, repay.
- Read and understand all credit contracts
- Pay debts promptly
- Notify your creditors if you cannot make your payments
- Immediately report lost or stolen credit cards or compromised personal information to your issuing bank and credit reporting agencies
- Never provide credit card numbers over the phone unless you initiated the call or are certain of the caller’s identity
Importantly, be sure to make saving for the future part of your overall strategy.
Marilyn F. Booker
Managing Director and Head, Urban Markets Group
Morgan Stanley Wealth Management