You may have heard others talking about their credit scores or the interest rate on their mortgage. You may also have heard friends or family members talking about collateral or using equity in a home to consolidate debt. However, you may not understand what those things are or how they can impact your life. Let’s take a look at some basic credit terms and why they are important to understand.
What’s a Credit Score?
A credit score is a way for lenders to determine how well a borrower has handled previous or current debt obligations. Credit scores range from 300 to 850 under the Fair Isaac Corporation (FICO) scoring model. Lenders generally won’t give loans to those who have a score of less than 600, and they generally reserve the best rates for people who have scores of at least 700 or higher.
How Is a Credit Score Determined?
Credit scores are determined by a variety of factors such as credit utilization rate, credit mix and payment history. Ideally, you will use less than 30% of all available credit limits. Keep in mind, this utilization rate is calculated periodically, usually at the time your interest payment is calculated, so a higher utilization will not immediately have an impact just as reducing your utilization will not immediately benefit you. It is also a good idea to have at least one secured and unsecured loan on your credit report. Working with a company such as Trout Associates can help you analyze your report and create strategies to improve your score.
Why Are Credit Scores Important?
Your credit score is important because it determines the amount of interest that you pay on an auto or home loan. It can also determine your insurance premiums or whether or not a landlord will require a security deposit to lease an apartment. A low credit score can make it harder to get certain jobs as it indicates that you aren’t responsible or may be vulnerable to outside pressure.
How Can You Improve Your Credit Score?
The easiest way to improve a credit score is to make debt payments on time. If you have any payments that are past due, be sure to make those payments as soon as possible. Lenders may also agree to roll a past due amount back into your current balance. Paying down a credit card balance can be another effective strategy as it will reduce your credit utilization rate. Alternatively, you can apply for additional credit or transfer a balance from a card that is maxed out to one with a lower balance.
What Is Collateral?
Collateral is anything of value that is used to secure a loan. For example, a mortgage is generally secured by the home that a borrower lives in while an auto loan is typically secured by the vehicle itself. Personal loans can also be secured by a home, vehicle or anything that can be liquidated by the lender if a borrower defaults on the loan.
What Is Debt Consolidation?
Debt consolidation allows you to combine multiple loans into a single consolidated loan, typically with both a lower interest rate and overall lower balance. Generally speaking, it can be easier to keep track of one payment and due date compared to the three, five or 10 that you have currently. Furthermore, that payment may come with a lower interest rate, which means that you are paying more of your principal balance each month.
Examples of debt consolidation loans include credit card balance transfers and home equity loans. As the name implies, home equity loans allow you to borrow against the value of your home without the need to sell it. Typically, such loans come with interest rates similar to the average national mortgage rate. If you need help determining the best way to consolidate your debt, talk to Trout Associates or other financial professionals in your area.
It is critical that you understand how to manage your finances. Part of effectively managing your finances is understanding how credit works and how to use it responsibly. Local banks, financial bloggers and others may be able to further explain financial concepts in an effort to make managing money easier.