By Jerry Fetta
I think the most confusing thing about credit for people is they don’t really know what it is.
If I ask the average person what credit is they will actually give me examples of credit in use, rather than a true definition of credit.
In this article I aim to simplify credit so that you as the reader can get true information to apply in your life about credit.
So let’s start with the definition of credit.
The dictionary defines the noun credit as:
“The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.”
Investopedia defines it as:
“A contract agreement in which a borrower receives a sum of money or something of value and repays the lender at a later date, generally with interest.”
And there is also a definition of credit that actually refers to a person’s creditworthiness. For example, I have good “credit” really refers to my creditworthiness rather than the actual definition of credit.
So what is credit?
In my simple definition, credit is a representation of trust backed by obligation.
What do I mean? The bottom line of credit is that a borrower is accepting a loan from a lender to purchase things with the lender’s funds instead of the borrower’s own funds. Sometimes this is because the borrower does not have funds and is spending what they don’t have and can’t personally afford. Sometimes this is because the borrower does have their own funds, but would rather use the lender’s.
Regardless of why a loan is being agreed upon, that loan is initiated based on trust. The lender trusts the borrower to repay.
That loan is backed by obligation. If the borrower does not repay the lender then the lender can take away assets from the borrower, known as collateral, or let others know that this borrower is not trustworthy (or creditworthy) by putting a negative remark on the borrowers credit report.
So credit is trust, backed by obligation.
The next thing I want to do is actually start at the very top with a Credit Score and work our way backwards.
A Credit Score is what most people use to measure their credit health. An arbitrary number is given to them with a ranking system that is based on the contents of the person’s credit report.
A Credit Score can range from the 400’s or 500’s (very bad) up to the 800’s (very good). An average credit score is the mid 600’s to 700. Anything in the low 600’s or lower is considered bad credit (poor creditworthiness) and anything above 700 is considered good and even excellent credit as the score gets closer to 800.
But again a Credit Score is based on the underlying credit report (also known as a credit profile).
The Credit Report is very much like your report card as a borrower.
Again, a credit score is essentially a statistical representation of being a trustworthy borrower.
So to have a high credit score I need lots of indicators that I have borrowed and successfully repaid what I borrowed, as agreed.
This means lots of different variety of loans such as revolving credit lines (credit cards and lines of credit), fixed loans (car loans, student loans, etc.) and even mortgage loans. This shows that lots of other lenders have trusted me with various types of loans.
I also need a long history of paying my loans on time. The longer I pay on a loan, it shows a track record that over time I am trustworthy and stable as a borrower. If I miss a payment, it shows I am less trustworthy. Now, another thing to consider is that if I pay these loans on time, but then pay them off early, I actually interrupt the track record reporting on my credit and it can negatively effect my credit. Paying something “as agreed” actually means I pay it per the agreed upon term with my lender.
For example, if I get a car loan and agree on a 60 month term length and then I pay it off in 24 months, my credit score will go down. Even if I paid on time for the 24 months. Why? Because I closed a credit line down and this means that there is one less line reporting on my credit and also it means I didn’t keep my agreement with the lender. The lender doesn’t want me to pay off my debts early because they don’t earn interest when I do that. This doesn’t mean I should never pay off loans early, but it is something to be aware of and to defend against in other areas.
The other factor is how much of my available credit lines I use. This would effectively be high balances on my loans. If I have $10,000 in available credit lines and I have borrowed the full amount, that is a very bad indicator to other lenders. It means I already owe a lot to other lenders that I have not repaid. So another lender will view me as a higher risk because I already owe so much to others.
The last big one I’ll cover is the number of times I inquire about loans. When I request a loan, a potential lender looks at my credit report. When they do this, an “inquiry” is put on my credit report signifying that I asked for a loan and a lender is looking at my report. If I have an excessive amount of inquiries it tells lenders that I am going around asking for lots of loans. This is fine within reason, but if it is excessive then it is a major red flag to lenders.
Now if I have a low Credit Score this can mean many things, but essentially they are just the opposite of what’s been covered above.
It can mean any number or all of these factors:
- I have little or no credit history
- I don’t have a variety of different loans that I pay on
- The payment history on my loans is very short
- I have late payments
- I have failed to repay my loans
- I’ve paid off too many of my lines early, closing the lines
- I have too much debt
- I’ve excessively asked for loans (too many inquiries)
I know that’s a lot, but when I learned what my credit score was, how it worked, and how I could control it it helped me quite a bit.
But all of this aside, the main thing we need to know that has not been covered yet is the true purpose of credit.
This is the purpose based on financial freedom.
The purpose of credit is to have cushion available in an emergency when my cash reserves are not sufficient, to have excess funds available for opportunities that pay for themselves, to earn cash back rewards on my purchases, and to acquire assets and passive income for as long as I’m alive.
The purpose of credit isn’t to buy things I can’t afford or to impress my friends or to get a new car or any of the majority of things most people use credit for.
I use credit for a 2nd source of reserves. I keep 6 months worth of expenses in available credit at all times in addition to my 6 months of cash reserves.
I use credit to borrow against my hard assets (gold, silver, real estate, etc.).
I use credit to get cash back rewards when I buy things.
I use credit to invest in assets that pay themselves down and off over time.
That’s really it!
In summary, credit represents my trustworthiness, but it does obligate me and it obligates me to groups (banks) that often are untrustworthy and who don’t have my best interests in mind. I need to know that and understand who is on the other end of my loans as a lender when I borrow.
It’s okay to deal with the devil as long as you know he’s the devil and you act accordingly.
If this article helped you, I want to invite you to grab a copy of my book The Blueprint To Financial Freedom where you will learn more about how to get out of debt, become creditworthy, and to maximize your credit to create greater financial freedom for you and your family.
Click here to grab a copy!
To Purpose, Wealth, and Freedom.
Jerry Fetta is the CEO and Founder of Wealth DynamX. He is a nationally recognized financial expert featured in Forbes, Yahoo Finance, Fox, Chicago Weekly News, New York Finance, interviewed on over 45 podcasts with world renowned experts, earning endorsements and affiliations throughout his career with names like Grant Cardone, Dave Ramsey, and Pamela Yellen.
Jerry’s mission in life is to help create millions of financially educated and solvent families achieving greater financial freedom and sharing the truth about money with those around them.
Learn more at www.WealthDynamX.com
(DISCLAIMER: The information in this content should not be considered tax, financial, investment, or any kind of professional advice. Only a professional diagnosis of your specific situation can determine which strategies are appropriate for your needs. Wealth DynamX can and does not provide advice unless/until engaged by you.)