Personal Financial Planning: An "How-To" Guide (part 28)

Establishing Credit

by

Charles Lamson

The willingness of lenders to extend credit depends on their assessment of your creditworthiness---that is, your ability to repay the debt on a timely basis. They look at a number of factors in making this decision, such as your present earnings and net worth. Equally important, they look at your current debt position and your credit history. Thus, it is worth your while to do what you can to build a strong credit rating.

First Steps in Establishing Credit

First, open checking and savings accounts. They signal stability to lenders and also indicate that you handle your financial affairs in a businesslike fashion. Second, use credit---open one or two charge accounts and use them periodically, even if you prefer paying cash. For example, get a Visa card and make a few credit purchases each month (do not overdo it, of course). You might pay an annual fee or interest on some (or all) of your account balances, but in the process, you will become identified as a reliable credit customer. Third, obtain a small loan, even if you do not need one. If you do not actually need the money, put it in a liquid investment, such as a money market account or certificate of deposit. The interest you earn you should offset some of the interest expense on the loan; you can view the difference as a cost of building good credit. (It goes without saying that you should repay the loan promptly, perhaps even a little ahead of schedule, to minimize the difference in interest rates---do not pay off the loan too quickly, though, as lenders like to see how you perform over an extended period of time.) Keep in mind, your ability to obtain a large loan in the future will depend in part on how you managed smaller ones in the past.

Build a Strong Credit History

From a financial perspective, maintaining a strong credit history is just as important as developing a solid employment record! Do not take credit likely, and do not assume that getting the loan or the credit card is the toughest part. It's not. That is just the first step; servicing it (i.e., making payments) in a prompt and timely fashion---month in and month out---is the really tough part of the consumer credit process. And in many respects, it is the most important element of consumer credit, as it determines your creditworthiness. By using credit wisely and repaying it on time, your establishing a credit history that tells lenders you are a dependable, reliable, and responsible borrower.

The consumer credit industry keeps very close tabs on your credit and your past payment performance. So the better job you do in being a responsible borrower, the easier it will be to get credit when and where you want it. The best way to build up a strong credit history and maintain your creditworthiness is to consistently make payments on time, month after month. Being late occasionally---say two or three times a year---might label you a "late payer." When you take on credit, you have an obligation to live up to the terms of the loan, including how and when the credit will be repaid.

If you foresee difficulty in meeting a monthly payment, let the lender know and usually some sort of arrangements can be made to help you through the situation. This is especially true with installment loans that require fixed monthly payments. If you have one or two of these loans and, for some reason or another, you encounter a month that is going to be really tight, the first thing you should try to do (other than trying to borrow some money from a member of the family) is get an extension on your loan. Do not just skip a payment, because that is going to put your account into a late status until you make up the missed payment---in other words, until you make a double payment, your account/loan will remain in a late status, subject to a monthly late penalty. The alternative of trying to work out an extension with your lender obviously makes a lot more sense.

Here's what you do. Explain the situation to the loan officer and ask for an extension of one (or two) months on your loan. In most cases, so long as this has not occurred before, the extension is almost automatically granted. The maturity of the loan is formally extended for a month (or two), and the extra interest of carrying the loan for another month (or two) is either added to the loan balance or, more commonly, paid at the time the extension is granted (such an extension fee generally amounts to a fraction of the normal monthly payment). Then, in a month (or two), you pick up where you left off and resume your normal monthly payments on the loan. This is the most sensible way of making it through those rough times because it does not harm your credit record. Just do not do it too often. To summarize, here are some things you can do to build a strong credit history:

• Use credit only when you can afford it and only when the repayment schedule fits comfortably into the family budget---in short, do not overextend yourself.
• Fulfill all the terms of the credit.
• Be consistent in making payments promptly.
• Consult creditors immediately if you meet payments as agreed.
• Be truthful when applying for credit. Lies are not likely to go undetected.

Smart.sites The American Banker’s Association provides helpful information about shopping for credit and managing debt at its site, www.aba.com.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 230-232*

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Smart.sites

The American Banker’s Association provides helpful information about shopping for credit and managing debt at its site, www.aba.com.