Introducing: The Credit Score
A credit score is like a "grade" on your creditworthiness. The higher the score, the better. So what makes up a credit score?
Banks and companies have to make thousands of decisions every day regarding how much credit to provide their customers. Credit is the maximum amount of money they are willing to allow you to borrow. The decisions they make are based on what is known as the 5 C's of Credit.
The Five C's of Credit
Capacity: Capacity refers to the ability to repay the debt. The lender looks at your income and your other financial obligations to determine your "capacity" or ability to repay. If you have a lower income but no other debt obligations, you may have a higher capacity than someone with high income but a large mortgage and student loan debt.
High Capacity Example: Executive making $1 million each year with no debts.
Low Capacity Example: A person who has been unemployed for 3 years. No income=no capacity to repay.
Capital: Capital refers to the borrower's net worth, or wealth. The lender will be less worried about loaning to a person with a high savings account balance with few debts than to a person with no emergency fund and high auto loans.
High Capital: Someone who has money in the bank and few large loans.
Low Capital: A person with no emergency fund and large debts.
Conditions: Conditions refer to the state of the economy (national and local) and the availability of money. If the economy is not doing well, the lender will be less willing to provide credit.
Good Conditions: Thriving Economy
Bad Conditions: Depression or Recession
Collateral: Collateral refers to an asset pledged against a loan to give the lender more security that the loan will be repaid. The lender is more confident about getting at least some of the money back when there is collateral.
Example of Collateral: A car or home that you are borrowing on.
Character: Character refers to the lender's assessment of the person's experience repaying debt. Consumers who have failed to repay debt to other banks or companies will find that credit is harder to get and more expensive in the future. Credit becomes more expensive when banks and companies feel that the risk in providing credit is very high. When the risk is high, they charge higher interest rates on the credit they provide.
Good Character: Always pay bills on time.
Bad Character: Never open bills, pay them late if ever.