consumer credit

How Does Consumer Credit Work? (Guest Post)

by Vinh Tran

As a first generation immigrant, I have seen first-hand my family’s struggle to understand the U.S. credit system (FICO) and ultimately gain access to consumer credit. The U.S. credit model is complex enough that many native-born Americans still lack a full understanding of its impact on the cost to them over a lifetime. Landlords use consumer credit scores to evaluate potential renters; employers may also use credit scores to make hiring decisions. A good FICO score translates into lower insurance premiums, as well as lower interest rates when financing a car or home purchase. Therefore, understanding the credit system is an important passage to assimilating into life in the U.S.

My own family history gives me a greater appreciation of what foreign-born individuals face and shapes how I help clients. It motivates me to do my job as a Mortgage Banker and Educator of the credit system differently than others. Every day I have the privilege of helping clients realize the American dream of  home ownership by removing the barriers to make their dream possible. It all starts with education.

There are roughly 30 countries with a national credit system, but the U.S. system is one of the most developed and complex in the world. While some countries only report negative activities, the U.S. reports both positive and negative activities, thus giving the most comprehensive view of a person’s credit worthiness. The scoring model is an intricate system of algorithms that tries to capture a person’s likelihood to pay their debts. The FICO score is a statistically derived numeric value based on information from the credit report. It reflects a combination of someone’s credit “character,” as well as their understanding of how to play the consumer credit “game.” It has more to do with one’s ability to interface with the system at a high level by managing the activities of credit, and less to do with honesty and integrity.

Below is a snapshot of how the “game” is set up. Playing by its rules accelerates the process of gaining the FICO points that make someone a perceived better risk to potential creditors.

PAYMENT HISTORY: 35%

  • Regardless of what country you are from, you instinctively know that paying your debt on time is good and not paying on time is bad. But since payment history is only 35% of FICO scoring system, simply paying on time doesn’t always yield a great score.

CREDIT MIX: 10%

  • The credit model sees the ideal credit mix as someone having a mortgage, an automobile loan, and 2-3 credit cards. It is designed to reward those who successfully manage both installment loans (mortgage & car) and revolving lines (credit cards).

INQUIRIES: 10%

  • Each time a person tries to open a credit account, it is considered an inquiry into credit. This portion is only 10%, but each inquiry does have a negative impact on the overall score, regardless of whether or not they actually open another account (which is why it’s labeled as inquiry and not “account opened”). For someone getting started, there is no way to avoid the initial negative impact. Over a period of time, the negative impact will wear off.

LENGTH OF HISTORY: 15%

  • Lenders minimally want to see a two year history of good activity. Once a credit card account is opened, it is important to keep it open because the credit model also rewards the longevity of open accounts. For this reason, people with higher credit scores are typically a bit older as it takes some time to establish and raise one’s scores.

UTILIZATION: 30%

  • Utilization is the percentage of credit limit that one uses. If you have a $1000 credit limit and a $200 outstanding balance, then your utilization is 20%. Negative points are assigned once 10% utilization is reached. The closer you get to 100% utilization, the more punitive the impact on the score. In general, staying under 30% is ideal.

The first step in establishing consumer credit is to obtain a secured credit card, in which the credit limit (typically around $500) is secured by a deposit made in advance to the bank. Depending on the bank, this deposit may be returned to you at some point, and/or the card is converted to a non-secured credit card. Over time as you establish a good payment history, many credit card offers will be made available. Having 2-3 credit cards through Visa, MasterCard and/or Discover is better than a department store card.

The next step toward creating the ideal credit mix is obtaining a car loan. Even if you can pay for a car with cash, it’s a good idea to finance a small portion to accelerate the process of establishing credit.

The pinnacle of consumer credit is a mortgage. If you want to eventually buy a house on credit (mortgage), most lenders will want to see at least two years of good credit activities. Those activities include on-time payments to your creditors, good rental history and the projected ability to handle a new mortgage debt.

Vinh Tran is licensed in Missouri and Illinois as a Mortgage Banker and has extensive experience with credit policy creation. He is approved by the Missouri Real Estate Commission as a Continuing Education instructor on the subject of CREDIT to realtors. He can be found via LinkedIn or www.vinhtran.net.