Collateral (Pledge Property)

Collateral, which is the value of your personal possessions and/or property, is another factor considered by lenders and creditors. Possessions may include such things as personal possessions of value, an automobile that is paid for, and real estate holdings. Even though these items would need to be sold or liquidated, their value may be considered as a factor in determining the strength of a loan application.

For example, if someone is seeking to borrow money and has very few assets (cash reserves) but recently inherited their grandfather’s house and is willing to offer the property as collateral, they may be a better credit risk. This is because despite the fact that the loan applicant may have limited cash reserves, the possession of the real estate may make the application very strong and thus a better credit risk.

The term commonly used for this type of situation is called “compensating factors.” If an applicant is very strong in one area, yet weak in another, compensating factors may be considered. Another example of a compensating factor may be having limited investments, but a high income.

Relative to a home mortgage approval, a large down payment (for example, more than 20%) may be a compensating factor for some credit imperfections.

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Credit (Credit Usage and Payment History)

One of the primary factors considered by lenders and creditors is your credit report. A careful examination and review of all of the information contained in the report will be made to determine your credit usage and payment history.

If the lender or creditor finds that the credit report contains several late payments or other negative factors—such as public record items, like a lien against your property or you have foreclosed on your previous home—your ability to secure loan approval will be severely hindered.

Furthermore, lenders and creditors will review the credit report to determine if you currently have “access” to too much credit. In other words, how many lines of credit or accounts are “open” and available to you? If, for example, you have several open accounts, even with a zero balance, you may be at risk of having the credit application questioned or denied because you could become overextended.

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Capital (Cash Reserves)

Capital is another term for cash reserves and includes possessions (property that could be liquidated). Lenders will look more favorably upon your application for credit if you can verify that you have cash reserves. Cash reserves may take the form of savings, money market funds, or other investments that can be converted to cash.

Cash reserves demonstrate to the lender that you have managed your money in a way to set aside extra funds and have resources other than your income to repay the debt.

Think of it this way:
Who would you be more likely to loan money to?

1. Your friend who is always “out of money?”
   
2. Your friend who has $3,000 in the bank?
   

Important note about investments: Lenders consider investments to be Individual Retirement Accounts (IRAs), certificates of deposit (CDs), stocks, bonds, and the like. Lenders do not consider pyramid scheme mechanisms as viable investments in any way.

Pyramid schemes operate on the principle that each member of a group will receive a profit or cut from recruiting others to join the scheme. It also assumes that every contributor participating in the pyramid would make full and timely investments each and every time. As the pyramid of contributors grows, it takes an increasingly vast pool of people to make sure everyone makes money; ultimately, it cannot be done. Remember that if you participate in a pyramid mechanism with your family and/or friends, a lender will not consider this a viable and secure means of savings or investments.

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Capacity (Income)

Your capacity is critical to the approval of a loan—that is, is your income sufficient to make the monthly payments?

With the extension of credit, lenders and creditors want to feel confident that you have adequate income to take on new or additional debt.

One of the ways that lenders verify your income is by reviewing your annual federal income tax returns. Administered by the Internal Revenue Service (IRS), income taxes are imposed on people living in the U.S. more than 180 days a year. As such, the IRS considers you a resident and the money you make in the U.S. is fully taxable. (You can obtain a tax identification number even if you do not have a Social Security number from the IRS. A tax identification number will serve as a way to record your income and file a tax return.)

If you work for an employer, a certain portion of your pay will be subject to “withholding” and be remitted directly to the federal and state governments before you receive your paycheck. If you work for yourself, you are expected to make estimated tax payments in advance to the IRS and state tax department on a quarterly basis.

On April 15 each year, you are required to file a tax return with the IRS for the previous year. The return will list your income and any allowable deductions or credits against that income. Once calculated, you will either owe more money in taxes or you will get a refund made up of the surplus tax dollars that you paid.

Note: If you earn a low or moderate annual income, you may qualify for a special tax benefit administered by the IRS. Known as the Earned Income Tax Credit (EITC), it is the largest federal aid program targeted to people with low-and moderate-incomes. Millions of taxpayers currently benefit from the tax credit annually yet many people who are eligible don't know it exists, how to qualify, or how to claim it.

People who qualify for EITC and file a federal tax return can get back some or all of the federal income tax that was taken out of their pay during the year. They may also get cash back from the IRS. Even people whose earnings are too small to owe income tax can get the EITC. For more information, contact the IRS 24-hour information line at 800-TAX-1040 or visit http://www.irs.gov/.

If you do not file income taxes in the U.S., begin doing so right away. It is an important way for lenders to document your income and income history so that you can obtain a loan or mortgage on a home. And, if you file your annual tax returns and end up qualifying for a refund, it will certainly brighten your day.

More on having sufficient income . . .

Who would you be more likely to loan money to?

1. Your friend who is without income and has no ability to pay you back?
   
2. Your friend who is working and has enough money left over to pay you back?
   

Lenders, especially in the case of mortgage lenders, will carefully consider debt-to-income “ratios.” Debt-to-income ratios are calculations or percentages of the amount of your gross monthly income that may be paid for monthly debts.

For example, a typical home mortgage qualifying ratio is 28/36. This means that no more than 28% of your gross monthly income can be used to pay for your principal, interest, property taxes, and insurance (PITI). Furthermore, no more than 36% of your gross monthly income can be used to pay for your PITI and other monthly debts. (Lenders consider your monthly debts as the amounts you owe on your loans and credit cards. Lenders do not require you to disclose the amount of any financial obligations you send back on a monthly basis to relatives who live in another country. However, it’s wise for you to consider these monthly remittances as part of your overall debt so that you can afford and be comfortable with your monthly mortgage payments over the long-term.)

It is also important to note that in addition to PITI, homebuyers who pay less than 20% down may be required to purchase mortgage insurance.

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Are You Creditworthy?

Take a minute and think about the following questions:

• What does creditworthy mean to me?
  
• Can anyone obtain credit? If so, at what cost?
  
• Is credit a right or a privilege? Do lenders owe me a loan (money)?
  

Very simply put, lenders and creditors consider four primary factors. These include capacity, capital, credit, and collateral. Each of these factors is examined next weeks blog.

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What is a Good Credit Score?

Because there are different credits scoring systems, there are several types and ranges of score values. Generally, the higher the score, the lower the predicted risk to the lender. (FICO scores, for example, range from approximately 300 to 900.)

It is very important to ask the lender or creditor to interpret your score for you. Because the scoring systems and the numerical ratings vary, never assume that your score is good or bad until it has been fully explained to you by a credit industry professional.

In addition, some credit scoring companies publish a distribution of their scores and the likelihood of a borrower to repay.

There are no quick fixes. Only perseverance and long-term, responsible credit management practices will provide you with a good credit score.

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Tips for Raising Your Credit Score

There are no quick fixes to improving your credit score. However, in an effort to ensure that your score is as good as it can be, you should seriously consider following the tips. These tips were provided by Fair Isaac. Fair Isaac’s credit scoring system, known as FICO scores, is one of the most commonly used credit scoring systems in the credit industry.

The item above regarding collection accounts deserves special attention. Collection accounts are the result of non-payment of a bill. For example, if you have a medical bill that went unpaid, the medical service provider may assign the bill to a collection agency. When this occurs, the account is listed as a collection account on your credit report.

If you pay off the money owed after being contacted by the collection agency, the record of this occurrence will stay on your credit report. It may indicate that the debt has been “satisfied” but nonetheless, the event stays on the report and will be viewed negatively by lenders and creditors.

First of all, even though it is sometimes tempting to take advantage of “special rates” such as low interest rates offered by some credit card companies, be careful! Oftentimes, these special rates are only “introductory” rates and may dramatically increase within a few months. ALWAYS read the fine print and ask questions!

Furthermore, balance swapping and shifting between credit card accounts will make your credit report look like the stock market—up and down, up and down. Remember, stability is key.

Because you want to always limit the number of inquiries that appear on your credit report, you should check out your financing options for a car or a home mortgage within a short period of time. Credit scores distinguish between a search for a single loan and a search for many new credit lines, in part, by the length of time over which inquiries occur.

The important point to remember here is that obtaining a copy of your own credit report for review does not affect your credit score. So go ahead and get a copy to ensure that its contents are correct.

Finally, closing an account does not remove it from your credit report. Remember, your credit report is a history of your credit activity.

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Can I Improve My Credit Score?

Of course, we all would like to know how to improve our credit score in an effort to secure credit at the best possible terms and conditions. However, because credit scoring utilizes data contained in your credit report, the scoring system is actually analyzing your credit patterns over an extended period of time.


In addition to credit scoring models taking your payment history into account, any older, past credit related items or occurrences, such as public record items, are also factored into the calculation.


Furthermore, credit scoring models tend to look for long-term stability. Therefore, radical changes to your credit report may trigger a negative impact on your credit score. Examples of radical changes include: closing several accounts, opening several new accounts, or even paying off all of your existing balances.


Bottom line: Expect improvement to take time and remember the best approach is to manage your credit responsibly over the long-term and to make sure that the information contained in your credit report is correct.

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What Is Contained in a Credit Score?

The actual end product of a credit score report will be an assigned numerical value. Lenders may provide you with your score and a list of the primary factors that may be negatively impacting your score.


You may obtain a copy of your FICO credit score online (for a fee). This Web site also offers additional information on credit scoring, factors, and credit tips (http://www.myfico.com).

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What Is the Purpose of a Credit Score?

As mentioned earlier, credit scoring utilizes only the information contained in your credit report. It is especially important to point out that your income level is not a factor considered in calculating a score. In other words, someone with a high level of income may have a low credit score, while someone with a low income may have a high credit score. It all depends on the past use of credit and the factors. The primary purpose of a credit score is to help lenders assess the level of risk.


In addition, using credit scores has helped lenders and creditors “speed up the process.” This automation has helped to reduce the amount of personal review time for a credit application and has brought about the nearly “instant” approval of a loan and evaluation of a borrower’s credit.


A credit score is also used by some creditors to help them decide based on your credit score and the predicted level of risk, what interest rate and/or loan terms will be offered.

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What Factors Influence Credit Scores?

There are a variety of ways that credit scoring companies determine a credit score. Based on the Fair Isaac Corporation (FICO) credit scoring model.

FICO is just one of the providers of credit scoring models. Therefore, it is important to note that other credit scoring models may use other variable categories.

Let’s consider, for a minute, some questions relating to each of the factors and the approximate weight given to each category.

1. Payment history: What is your track record? Have your payments been made on time? (35%)
   
2. Outstanding debt: How much do you owe? Do you have a high level of debt, that is, are you near the maximum on some or all of your credit limits? (30%)
   
3. Credit history: What is the length of your credit history? That is, how long have you had credit? (The longer the better.) (15%)
   
4. Pursuit of new credit: Does your credit report indicate that you have made numerous applications for new credit and are potentially taking on more debt? (10%)
   
5. Types of credit in use: Does your credit report show a “healthy” mix of credit types in use? The score will consider your mix of credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. It is important to note, however, that it is not necessary to have one of each, nor is it a good idea to open credit accounts that you do not intend to use. (10%)
   

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What Is Credit Scoring?

Credit scoring is the result of various computer programs which, when inputted with information contained in your credit report, generate a number which is your “credit score.”

Depending on the model used these numbers help the lender or creditors assess risk and “predict” the likelihood of a future default on your loan.

Credit scores are an important consideration in approving loan applications.

Credit scores are only a prediction. Yet, because the models have been developed based upon literally hundreds of thousands of credit report profiles, they are considered an excellent predictor of an individual’s ability to successfully repay a loan.

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What About negative Accurate Information?

Important note:

The seven year period begins at delinquency unless the account is placed for collection, and charged to profit and loss, or similar action. If the account is placed for collection, charged to profit and loss, or similar action, then the seven years begins 180 days after the date of the delinquency.

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