Principles of Credit
Unfortunately the prevalence of low financial literacy gets passed along into our education system, and many of our role models. The adage “get good grades, so you could go to a good school, so you could make a lot of money” is passed around as sound financial advice. Unfortunately this “sound” financial advise is trapping people into mountains of debt, that no amount of earned wages can free you from the cycle. The advise to go into debit isn’t all evil, the lack of financial literacy is what causes bad credit and ruins lives. The difference between living life or struggling to survive is based on your creditworthiness.
Our country runs off deficits (i.e. debt). Since 1971, when America left the gold standard we have been living primarily off credit. I want you to consider credit as similar to the new gold standard. If business and government uses credit to grow their revenues, why shouldn’t you. But it must be done wisely using the following principles.
Principle 1: Don’t take advise from broke people. Keeping up with the Jones’ will lead to financial ruin.
Principle 2: Pay yourself first, to build up your financial assets, that make money while you sleep.
Principle 3: Never owe more money on your debts, than you could sell everything you have (i.e. assets) to pay it back.
Principle 4: Do all that you can to increase your productivity. (investments in yourself and your assets). Your productivity should include building additional streams of income, that work while you are sleeping.
FINANCIAL LITERACY: HOW THE ECONOMY WORKS.
An economy is based off of a transaction between a buyer and a seller. A buyer will use money or credit to purchase goods, services or financial assets. The Largest Buyer in the economy is the Government who collects taxes (in the form of money) and the Central Bank (control credit with interest rates or prints additional money). Credit is the most important part of our economy and least understood.
Lenders want to make their money turn into more money, and Borrowers want to purchase something they can’t afford, like a car, house or a business. Credit helps lenders and borrowers get what they want. Higher Interest rates discourages borrowing, and lower interest rates encourages borrowing because it is cheaper. Hence why there is a difference in interest rates between various loan types.
Pay Day Loans 300% to 600%
Credit Card Loans: 15% - 25%
Small Business Loans: 4% - 200%
Personal Loans: 10% - 30%
Auto Loans between 4% - 20%
Student Loans: 2% - 18%
Home Loans: 1.5% - 7%
The interest rate is created to discourage certain types of borrowing and encourage other types of borrowing. (BEWARE OF TRAPS: 0% financing is enticing you to borrow for things that will ruin you.)
Once credit is created it becomes Debt. Debt is an asset to the Lender, and a liability to the buyer. Assets put money in our pockets and liabilities take money from our pockets. When the borrower pays back the debt with interest, the liability is satisfied and the lender has the money as the asset.
Credit is important, because credit allows the borrower to increase his spending on various goods, services or financial assets. This spending drives the economy forward, by adding revenue to a business, which allows them to pay wages to employees and buy other goods, services and financial assets. Every dollar you spend, someone else earns, and every dollar you earn, someone else has spent. As income rises, the borrower is more worthy of credit. This is known as the Debt to Income Ratio. The total annual debt owed divided by the total gross income earned. Banks love to see anything below 43% as a worthy indicator to extend credit. When banks don’t follow this rule, the borrower often cannot repay, and the lender often will gain the reward of the collateral held for the loan. Bad Credit RUINS lives! The difference between living life or struggling to survive is based on your creditworthiness. Our economy is structured that creditworthiness effects your perusal and professional life:
Jobs use it to determine your character
Auto-insurance companies use it to determine your rates
Rates for future loans can be lower because of it.
Rental Housing companies use it to determine your trustworthiness.
INCREASE YOUR PRODUCTIVITY:
In a transaction you have to give something to get something, and what you are able to give is determined by what you are able to produce. This is called Productivity, the more productive you are the more you have to give, and likewise the more you are able to get. Someone who works hard and is smart (has a high financial IQ) with their time/money can receive more, and someone who works the bare minimum and silly (has a low financial IQ) with their time/money will receive less.
Credit can allow the hardworking financially literate individual to be more productive, it creates leverage which is able to scale up their ability to use their time more efficiently and increase their incoming money supply. However, there is a point in which you can be over-leveraged, and have too much credit, and you must spend less than you make to pay back the debt that you owe. This principle is true regardless of whether you have high financial literacy or low financial literacy. This is known as a Cycle. This Cycle typically is recycled over months/years. Borrowing pulls spending forward, by creating a time in the future in which you need to spend less than you make, to pay the debt back so that you could then use leverage again to increase your productivity.
Therefore someone who is smart with their use of credit, will use it to leverage their productivity that will increase how much assets they have or income they are producing. Someone who is silly with their use of credit, will not use it as leverage but instead as a means to finance a lifestyle they cannot afford and thus not produce any additional income. For example, credit used to buy a rental home will produce income through the rent, and the debt pay down will increase your asset. But credit used to purchase a new personal car, the car will quickly decrease in value over time, and not produce any additional income by itself and the loan will often be more than the value of the car if you were to sell it to repay the loan.
CREDIT SCORING MODELS:
There are many credit scoring models but the most famous are the FICO (Fair Isaac Corporation) and Vantage. We won’t go into the details of differences between the two but for the most part their scoring is broken out fairly similarly.
CREDIT SCORING BREAKDOWN:
35% - Payment history
how often you pay your debt on time.
30% - Credit Utilization
The amount of credit available to you and what you currently are using
15% - Length of History
How long you’ve had credit available to you.
10% - Inquiries
Anytime you request a loan your credit history is pulled.
10% - Diversity of credit (Installment versus Revolving Accounts) You want a healthy balance
Installment loans - Mortgages, Auto, Personal Loans, essentially a fixed term to pay back the loan
Revolving Credit - Credit Cards, Lines of Credit, etc., there is no fixed term to pay back the loan.
HOW TO BUILD CREDIT:
Building credit takes time, it could take up to a year to establish a good credit history. Below are some simple starter steps to building a credit history.
Get a cash-secured credit card or a credit builder loan
Community Banks or Credit Unions are great at this.
Become an authorized user - ask a friend or family member with good credit if you could become an authorized user at no risk to them. You would be added to their credit history and as long as you don’t have a card in your possession you can’t use their credit.
Pay your bills on time
have rent and utility bills count towards the credit reporting agency.
Once you establish a history, get a credit card that pays you cash back. Take the cash back and invest in stock market funds.
Buy a house, preferably a duplex, live in one half and rent out the other.
Continue buying houses and renting them out to pay down the debt.
Avoid using a co-signer if you can. This will unnecessarily tie the co-signer to be responsible for the loan and it isn’t fair to them if you are not capable of managing the debt yourself. This is where being an authorized user on a credit card is helpful. You could be tied to a responsible person’s credit history, without having your credit history affect them. As long as they don’t give you access to the credit card or loan you are authorized on, they needn’t worry about your abusing the use of it.
Debt ruins lives when financial literacy is lacking. We are told to go into debt in order to get a good career, but this is often told to us through broke financial illiterate channels. Even if financial literacy is well established, greed and envy could drive you to break a principle mentioned above. Therefore, be careful with debt, use it sparingly for leverage to propel you forward in your productivity. Use the debt to help you establish streams of income that work for you while you are sleeping. Above all, remember the principles to not copy the spending habits of your broke friends, to never owe more than you can pay back, pursue productivity.