October 31st, 2016 6:22 AM by Michael and Jill Kohler
So you’ve finally made it to college. Your parents have been harping on you forever about the importance of getting good grades so you can graduate and get a great job making a lot of money in a field you love….. so right now you have no worries. I mean, you have the worries of writing that research paper by Thursday and of course doing well at school. But no “real life” worries. Or at least that’s what your parents say.
But one day in the near future, there will be no more assignments, pop quizzes or research papers due and you will finally graduate. You will likely celebrate your achievement of graduating from college (which is a huge one), frame your diploma on the wall, and head off to that place everyone’s been telling you for years that you know so very little about. The REAL WORLD.
Hopefully while in college you were smart and/or lucky enough to do an internship with a company in your field of study that might offer your first career prospect. I.e Job. Otherwise, you will begin searching for a job like millions of other graduates do every year. Eventually, or hopefully sooner, you will land that job and begin to put that expensive education to work for you.
After finding employment, maybe your goal is to begin paying off your student loan debt, saving money to buy a new car, or perhaps you’re thinking of buying a house or condo of your own in the future. Or you’ll move out of your parents’ house and rent an apartment for a while. No matter what path your life takes from this point, your credit is going to become a huge piece of that puzzle.
Why is this so important? Well, for starters, you may have heard that things are EXPENSIVE. And if we wait to save up the money for everything we’d like to buy in life and pay cash. Well, we are likely going to be waiting a long time for things, or have very few things. “So ok, I’ll just take out a loan” you say. And that’s where the basic need for credit comes into play. In short, to buy the things we can’t afford to pay cash for. We borrow.
“So when I go to get a loan, what do banks and lenders look for?”
The top things that lenders will look for when you borrow money are the three C’s. That is, your Credit, your Capacity, and your Collateral. You may have heard and maybe even gained some understanding of these terms in your finance or economics class. Those are the primary factors a bank or lender will look at to determine your ability to borrow so here’s how they may apply to you in the “Real World” we were talking about earlier.
Credit: There are 3 major companies out there that keep track of your credit by your social security number. You do remember that number right? They are Experian, Equifax, and Trans Union. Each one of these companies keeps a report on any credit account you open. Not your school lunch account, but your Macy’s cards, or your gas card, or your student Visa or Discover card, and of course, your school loans. Each account has a detailed history that lenders can see your credit limit, how much you borrowed, how much you owe, and how well you paid on the account among other things. If you make your payments every month on time, you’ll be rewarded with a high credit score. This will likely generate offers from other banks and credit cards who will want to loan you money because you’ve demonstrated you can pay on time. In the case of credit cards, this is known as unsecured debt. If you buy a watch on your credit card at the mall, and decide to stop paying, they are probably not going to come looking for you to return the watch. However they will make negative reports on your credit. And the next time you go to open a credit card or apply for a loan, that poor payment history will reflect on your report, and you will likely have some trouble getting the credit you seek. Conversely if you pay your bill every month on time, your payment history will reflect positively.
Capacity: The 2nd C. This is a tricky one. A bank or lender will look at your income and make a determination (through a series of ratio’s and calculations) of whether they feel you have the capacity to pay for the item you are borrowing to buy. Let’s say in the case of getting a car loan. Example: You want to buy a $7000 used car to save money. You find a nice car you like on Auto Trader and you have $1000 saved to put towards the car and need to borrow the remaining $6000. You have a part time job making $150 a week and a couple of credit card bills you are paying on from things you bought while you were at college. The total of your credit card payments is $50 a month. This car loan might be $275 a month, plus your $50 a month on your cards, so you’d need at least $325 a month just to make the payments. Lenders also know that this car will need to be insured. That might cost you another $120 per month, and your car will also need gas. Let’s say a $30 tankful per week because you want to drive it right. That’s $120 a month. We haven’t gotten into repairs yet but I’ll save that for another article. So the lender adds this all up and determines. This applicant make $600 a month, but by the time they pay their credit card bills, pay the loan on the car, insure it, and put gas in it. They are going to spend $565 per month buying, insuring, and fueling this car, plus their credit card bills. That leaves about $35 bucks a month left in their wallet. Or $8 a week. What happens when the car needs a $500 repair. You do know that cars sometimes need repairs right? In any case, there’s a good chance that you may get denied for this loan (even if your prior history is good) Why? Because the lender has determined that you don’t have the CAPACITY to pay for it and afford other normal things in life with your 8 bucks a week that’s left after paying for it.
Collateral: The 3rd C. Collateral in a basic sense is something of value pledged for the payment of a loan. So for instance, when you go to buy a house one day, it’s primarily the value of the home you’re buying that you are pledging to the bank to guarantee that you will make the payments. Of course a lender will want to see your good credit history, and that you’ve made your car payments on time, because buying a home is a much bigger step. But they are going to be very concerned that the value of the home (the collateral) is worth more than what you are borrowing to buy it. That value of the home insures the bank that if for some reason you cannot make the payments on the loan, they can take that collateral back to satisfy what you owe them, which in this case is the house. I think it goes without saying that you want to try to avoid this situation as it can have disastrous consequences on your ability to borrow in the future.So there you have it, that’s the basics of Credit, Capacity and Collateral.
Open up a small charge account or two and make the minimum payments every month, even if it’s $10. Demonstrating you can borrow money and repay it on a schedule is a great first step. Paying off your balance in full doesn’t do much to build your payment history or FICO score. Unless you charge something one month, pay off the full balance, then do it again next month. Let’s say your gas card. You charge $60 worth of gas on your credit card, then pay off. Then the following month charge $60 more gas, and pay that off, etc. This will definitely help build your credit (and save you some interest as well) but that’s another topic.
Your initial credit card limit may be rather small, maybe $300 to 500 dollars. Or in some cases, you may need to get a secured credit card, which basically means you put up the cash as collateral (remember that) and you basically borrow your own money back but you build your credit by doing it. Some of these credit cards may have an annual fee. By paying on time every month, you will build your credit history and qualify for higher limit credit cards (some with much lower interest rates) like Visa and Mastercard. Continue demonstrating a solid payment history on these cards and in time, apply for better cards with less fees, lower interest rates and higher credit limits. A successful payment history will help you qualify for the loan on that new car you may be hoping to buy after graduation. Make sure you monitor your credit periodically and make sure that the accounts that are on your credit report are yours and are reporting accurately. You can request a free copy of your credit reports once per year from Experian, Equifax, and Trans union. You can also dispute items that appear incorrectly.
For many students, one day this credit experience may lead to buying that home you may dream about to raise a family in. When you sit down with your lender one day in the future to discuss your possible mortgage loan, he or she will be making determinations on, yep you guessed it, your credit, your capacity and your collateral so pay your bills on time, use your credit responsibly and you will find this process much easier. Years ago home buyers would need to put down 20% of the purchase price as collateral to get a home loan. Today, there are a number of low down payment programs backed and insured by the government called FHA Loans which will allow you to qualify for a mortgage with as little as 3.5% down. More options are becoming available to make the dream of home ownership a reality for your upcoming generation but developing a solid credit history will go a long way toward reaching that dream. Best of luck to you and hope this information helps in your journey.
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Author: Mike Kohler
Source: Net Equity Financial