Credit 101


One of the most daunting parts of the home buying process involves getting a mortgage. Before you ask a lender to help you finance your new home, you need to understand the basics of credit and the how the strength of your own credit history will impact your ability to qualify and how much you pay.

Credit 101


    What is Credit
    Credit is the term used when a person or company allows you to use their money for some reason with the expectation that you pay them back. You become the borrower, and they are the creditor.

    Types of Credit
    The two main types of credit are installment loans and revolving loans/lines of credit. Installment loans are loans where money is given up front and paid off over a specified period of time. These loans are often linked to a specific item (like your car) and that item can be seized by your creditor if you fail to pay. This is called collateral. Home loans (e.g. mortgages) are typically installment loans.

    Revolving credit (like your credit cards) allow you to draw against it at any time, up to a pre-specified limit set by the creditor. Payments are typically made as a percent of the overall debt outstanding.

    Principal and Interest
    When you make credit payments, there are generally two things you are paying. Principal is the initial amount that you borrowed that you have to repay in full and interest is what you pay the creditor for the use of their money. Principal is expressed in dollar terms while interest is usually calculated as a annualized rate and expressed in terms of a percent.

    For example: if you take out a one-year loan for $100,000 at a rate of 7%, you will end up repaying a $100,000 in principal and $7,000 in interest. In this example, the $7,000 that you are paying is the profit that your creditor gets for letting you use their money. The actual calculations for a real loan are more complicated, but you get the idea. You determine what the principal is when you take out a loan, but the creditor will tell you the interest rate that they are willing to lend to you at.

    Determining the rate you pay
    When someone lends you money, they are taking a risk. They are taking a risk that you won't pay them back, they're taking a risk that you'll pay only when sued (this is expensive) and they take the risk that they can make more investing in something other than your ability to pay. They're betting on you, and the riskier the bet, the more you'll need to pay.

    There are many factors that come into play when setting your interest rate; How much money you make, how many other debts you have, the collateral you're putting up and other things about you. None is as important as your history of paying back other people. Unless you're using Ralph's Loan Sharking and Broken Legs, your payment history will be recorded and reported. If you have a limited credit history or worse, a history of missed payments, expect to pay a higher rate of interest.

    Please note that this is the perfect-world scenario. In the world that we live in, unscrupulous lenders will sell you a loan at the highest interest rate you'll agree to, regardless of your credit. That's why it's important that you know how your own credit stacks up and what is reasonable.

    Credit bureaus
    Credit bureaus are independent organizations that maintain databases of consumer credit histories. Most creditors report account information on their borrowers and this information becomes a credit profile of you. For each account you have, the credit report will show the amount you borrowed, your monthly payment and whether or not you've been on time or late. Public record information (such as liens, judgments, and bankruptcies) will also be listed on your credit report.

    The three main credit reporting agencies in the U.S are Equifax, Experian, and Trans Union.

    Evaluating your credit with credit scores
    There was a time when in order to get a loan, you would sit down with a banker and she would review each line of your credit report. Nowadays, credit decisions can be made instantly using your credit score.

    Your credit score is a number between 300 and 850 that is calculated based on your credit history. The higher the score, the better. This number helps the lender identify the level of risk they may be taking in lending to you. Factors influencing the score include how long you've had credit, how many credit accounts you've paid as agreed, how many civil actions have been taken against you and how much of your available revolving credit is in use.

    Credit bureaus closely guard their credit scoring recipes, so there is not magic bullet to improve your score. Just understand that if you don't show through action that you're a dependable borrower, it will be more expensive (if not impossible) for you to get loans in the future.

    Checking your credit
    Before you even think about buying a home, you need to know what shape your credit is in. One of the easiest ways to do this is to visit our partner Credit.com for free copies of your credit report from each of the three main reporting agencies.

    Once you have your credit report in hand, your first course of action is to make sure that every account listed actually belongs to you. If you see accounts on your file for debts that you did not agree to, contact the credit bureau immediately using the contact information provided on the credit report.

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