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CREDIT 101

What Events Determine a Need for Credit?

Generally speaking there are four life “triggers” that effectively signal it’s time to apply for credit:

  • Buying a home
  • Getting a college or advanced degree
  • Buying an automobile
  • Establishing a credit history using credit cards

Of course there are other instances, such as healthcare costs, marriage and divorce, but for the most part those top four normally jump start any credit applications. The follow-on question then becomes: What do I have to do if I’ve found a home to buy, a car to drive, or a school that meets my educational goals?

While initially it may not seem obvious, the first thing you need to do is to establish a good credit history before you apply for credit. Sounds easy, right? Not exactly. Applying for credit without an established track record means most lenders may not want to take a chance on you as they have no idea what your payment pattern is like. It’s known as the credit “Catch 22.”

If you don’t currently have credit cards, bill payments or other documented forms of timely repayment, there are ways to get started, including “secured” credit cards. In addition to building credit, these cards also help repair damaged credit. They differ from regular credit cards because you must first provide an initial security deposit, and your line of credit is very restricted. You then build your credit, or repair it, by making on-time minimum payments to all creditors and maintaining account balances below credit limits. As in all instances, it pays to shop around to get the best deal, including annual or monthly fees, interest rates, liability, and access to alerts and other online payment offerings. A good caveat to follow? Establish a proven track record with one card before moving on to anything else.

How do you apply for credit?

Once you have a successful track record established, how do you apply for the credit you need to acquire a credit card or buy that home, car or education?

As we’ve mentioned before, your first priority should always be to ensure your credit history is accurate. Each year you are entitled by law to a free copy of your report from the top three Credit Reporting Agencies (CRAs): Equifax, Experian and TransUnion. Carefully review your history and if you find any mistakes, work quickly to get them fixed, either on your own or working with an experienced company you can trust. If your credit history is poor based on bad payments, get started immediately by clicking here.

Once you’ve made any necessary corrections or improvements to your debt payments and improved you score, now’s the time to start applying.

Credit Cards

As with most things, when you apply for a credit card, do your research. What type of rules do they have governing usage and due dates? What is the interest rate? Do they offer perks like cash back or mileage and are they relevant or useful based on your monthly spending allotment?

Also key is whether or not they charge an annual fee and how much it is. Most companies will reduce or waive fees for frequent users or for consumers with good credit histories. What types of fees and interest they charge on principal payments should also factor into your decision, as should a reasonable grace period between the time the purchase is made and when interest charges are incurred. And don’t forget late fees and over-limit fees – two actions to avoid so you don’t damage your credit.

Once you’ve decided on a card or cards, keeping in mind some experts recommend opening only one or two cards at most, review the application requirements online and then assemble the information you need. This can include driver’s license number, social security number, work phone, current and previous residences, and even perhaps referrals. Then decide which application method works best for you: online, in person, over the phone, or via postal service. How you apply can affect how long it takes for review and approval.

Once you’ve decided and filled out your application, review it carefully. Mistakes on applications are a sure-fire way to get rejected. Satisfied with your answers? Then it’s time to apply.

Mortgages

Owning your own home is still considered the “American Dream.” But applying for a mortgage, and borrowing a large sum of money, is a serious step. Ensuring an accurate, error-free credit report is key as high scores mean lower interest rates, smaller down payments, and less (or no) extra costs for private mortgage insurance (PMI).

Before applying, you should also make sure your credit card balances are paid off, or very low. And don’t try to open new accounts, or close old ones, prior to applying as those actions can affect your score. Save up as much money as you can for your down payment (20% of the purchase ensures you won’t have to purchase PMI) remembering that the more you are able to put down, the better the lending prospect you become. Borrowers also need to have money available for closing costs (such as appraisals, inspections, title insurance, etc.) and possible points (a fee equal to one percent of the loan amount)

Which brings us to your debt-to-income (DTI) ratio. Know what you can afford to pay monthly (including principal, taxes, interest and insurance) to determine the amount you can reasonably afford to borrow over time. Lenders also look for steady sources of income, so don’t switch jobs or quit a current one just before applying.

After you’ve got your ducks in a row, determine what type of mortgage suits your situation best. There are fixed-rate mortgages where the interest rate on the loan remains the same throughout the entire term, whether that’s for 10, 15, or 30 years. An adjustable rate mortgage (ARM), begins with an initial fixed rate, but changes and adjusts according to a pre-determined schedule. Based on market factors, they can move up or down significantly making them riskier investments. Interest rates are usually lower, but on 30-year ARMs the rates are usually recalculated each year on the anniversary of the loan.

The caveat here? Don’t wait till you’ve found the home of your dreams to make sure your credit score is the best it can be.

Automobile Loans

As with any type of large purchase, your best bargain (and bargaining position) comes from paying cash-in-full as opposed to financing over time, but not everyone can afford to do that – especially when it comes to automobiles.

If that’s you, here are some important steps to take when you know it’s time to finance new wheels.

Step 1

We can’t say this enough. Know your credit score, and be sure it is accurate. People with higher credit scores get better interest rates on loans. If errors are dragging down your score, get them corrected before you start shopping for that new auto. If your score is low because you’ve been negligent paying bills on time, or if you are already carrying a heavy debt load, get to work on cleaning up your history. Even after just a few months, you will see improvement in your score.

If you don’t have the luxury of time, be prepared before you head to the dealership. Know what your score is, and understand the rates you should be offered. Shop around and get pre-approved by a bank or credit union. That way you know before buying what you can afford each month and how much it’s going to cost you. But don’t share that information with the salesman as it can hamper your ability to negotiate a good purchase price.

Step 2

Do your research! What do you want? A hybrid? A truck? A sporty coupe? Once you’ve determined what to purchase, it’s time to find out how much you can reasonably expect to pay. Edmunds.com and Kelly Blue Book are excellent resources that can help you shop prices for both used and new vehicles. By being pre-approved, you can further narrow your selection based on affordability. A general rule of thumb is to not pay more than 20% of your take-home pay (the after taxes amount) on all the vehicles in your household – not just yours.

Step 3

Understanding how car dealerships offer financing can help you avoid making costly decisions. If they are acting as the broker between you and the institution that is actually lending the money for the car purchase, expect additional fees and markups. Additionally, manufacturers’ low-interest offers are only usually available to those with good credit scores. You should also determine whether you save more money opting for a cash rebate or a low interest rate over the full length of the loan.

If you’re trading in a car that you owe more on than it is worth, you should not be buying a new car. The generally accepted practice is to roll that “negative equity” into the new car loan, but all that means is that you are continually paying interest on it for the length of the new loan. Instead of purchasing a new car, focus on paying off the old one and then trade it in or sell it before buying the next one.

Be aware that dealerships also make a good deal of money through financing and insurance. They do it selling “add-ons,” or items like extended warranties, paint sealant and fabric protection. More than likely, these are luxuries you don’t need and you can save yourself additional money by steering clear of them.

Student Loans

Next to buying a home or a car, paying for your education after high school is likely one of the biggest expenses you’ll face. According to CollegeRank.net, a website that provides students with wide-ranging information to help them make informed decisions about attending college, in 2016 college graduates had an average of more than $37,000 in debt. For others, that rate was much higher. The site goes on to advise before taking out a student loan to consider what your repayment schedule will be. But before you even get to the point of applying for a student loan, there are other options to consider.

On salliemae.com, they note there are 5 million scholarships worth up to $24 billion available based on hobbies, field of study, ethnicity, and religion. They also list four different categories under which you might search for applicable scholarships:

  • High school seniors
  • College students
  • Minority students
  • Women and single mothers

Another option is private and federally subsidized grants. These are most often need-based and are available from federal and state governments, as well as from local organizations and non-profits, or even the college or university you plan to attend. To apply for a government grant you must complete and submit the Free Application for Federal Student Aid (FAFSA). Do so early, experts at Sallie Mae advise, because many grants are awarded on a first-come, first-served basis.

If, after applying and receiving grants and/or scholarship monies, you still find yourself short on funds, it may be time to look at student loans – federal or private. To apply for federal loans, you must first fill out the FAFSA. According to Sallie Mae, in addition to the loan types listed below, the FAFSA also automatically determines your eligibility for other work-study aid and grants:

  • Direct subsidized loans – Must have demonstrated financial need as per federal regulations.
  • Direct unsubsidized loans – Non-financially need based.
  • Direct PLUS loans – Unsubsidized federal loans for parents of dependent students and graduate/professional students.

Each of these federal loans carries specific interest-plus-principle payback requirements. Be sure to fully review and understand what you will need to do to repay the loan before signing.

Another option for student loans is to go the private route. Unlike federal loans, your credit rating is a determining factor. In fact, reviewing your credit report is probably the number one item on your lender’s check list. So, be sure yours is error free before applying.

From that, lenders determine what interest rate you’ll be charged when the repayment schedule kicks in, as well as your overall worthiness as a potential loan candidate. Always remember, once you sign on the dotted line you are responsible for paying that money back – regardless of whether you graduate or not.

As with all loans, do your homework. There are a myriad of options, including banks and credit unions. If you are a full-time student, or have not established a credit history yet, consider a co-signer (such as a parent). Also, never borrow more than you need (cost of tuition and related expenses, such as books and housing). Facing a debt upon graduation approaching or exceeding $40,000 is monumental enough without adding unnecessary costs to it.

Retail Credit Cards

Retail credit cards are a great way to build or repair a tattered credit history. But they can also be easy traps to debt. Unless you plan to pay your bills off in full every month, don’t consider applying because they often carry very high interest rates. Getting in over your head can happen quickly.

There are actually two types of retail credit cards: private label and co-branded. The former is most often issued by a financial institution such as Citibank, Chase or Synchrony, and branded with the retailer’s brand. Approvals are most often easier, faster and more lenient. They are not accepted anywhere but that store. Co-branded cards (featuring MasterCard, AmEx, Visa, etc.) are accepted anywhere the co-brand is.

Typically you may be offered an easy application while shopping. Who hasn’t heard the line, “Would you like to open an X credit card today? You can save 10% on all your purchases.” Understand that each time you apply and/or open a retail credit card your credit history is checked. Most private label cards have pre-arranged relationships with lenders so even if you have no credit, or your credit is poor, you still stand a good chance of being immediately approved. Remember though, each time your credit is checked when you apply for a loan or card, it can lower your rating. That’s why many credit experts warn against opening too many retail cards in close succession.

Another option to consider is pre-qualification. Some of the larger banks offer you this opportunity by just providing your name, address, and the last four numbers of your social security. It’s known as a “soft” inquiry, and the lender is often able to tell you whether or not you will qualify for a credit card before you apply. Unlike the actual application, a “soft” inquiry does not appear on your credit report.

Once you’ve established credit, or are well down the road to repairing it, you will probably start receiving pre-approved card offers in the mail. Remember that these may not always be the best offers. Usually you have to shop around to find those. As in most credit circumstances, do your research to ensure you are getting the best annual percentage rate (APR) and reward perks.

Home Equity Loans

It’s probably best to define what home equity is first. Simply put, it’s the difference between the appraised value of your home and the amount of mortgage you still owe (Current Market Value – Mortgage Balance = Equity). That includes your initial down payment along with the amount you have paid off monthly since taking out the loan. For those folks who pay additional monies each month (over and above the required payment), equity grows faster. As your home increases in value over time, so too does your equity.

Home equity loans are considered second mortgages for a fixed amount or credit limit, at a fixed or variable interest rate, to be repaid over a set period or, in some cases, only interest is required to be paid. There are four things you must possess in order to consider this option:

  • Current equity: Lenders require a hefty amount of it before they’ll approve a loan against the value of that home. In most cases lenders will only lend on the equity in the home that is in excess of 20% of the current market value (i.e. $100,000 X 80% = $80,000 - $50,000 first mortgage balance = $30,000 loan amount).
  • Good credit: At the risk of sounding like a broken record, knowing what your score is before you apply for any type of loan is crucial. If it’s low, you must work to improve it by reducing current debt, making bill payments on time, and generally being a good steward of your money. A score above 700 is a generally a good marker for home equity approval. You can get one free copy of your report each year from the three credit reporting agencies. Make a habit of doing so and reviewing for any errors.
  • Income: How much you make, how long you’ve been at your job, and length of time in your particular field are all aspects that lenders will take into consideration when reviewing home equity applications. And, don’t forget your all-important debt-to-income ratio. They’ll need to see how much of your current income is already flowing out of your pocket to pay for the mortgage, credit card bills, car payments, student loans, etc. Most lenders want to keep that ratio below 36%.
  • Loan-to-Value (LTV) ratio: The lender gets an appraisal, or estimate, of the home's current fair market value, adds the current mortgage balance to the size of the equity loan you want, and then divides that by the home's current value. That’s your LTV ratio. The current rule of thumb is to keep the LTV below 80%.

Healthcare Credit

Medical emergencies, and even standard procedures and preventive care, can be extraordinarily costly. Deductibles alone today can put a major dent in your wallet. A trend that began taking off in the late 2000s, even though it had been generally available since the 1980s, was the advent of the medical credit card.

Applying for medical credit works much the same way as traditional credit. You apply online, in person or over the phone. Likely you will need to be 18 years or older, and on some applications you must supply the doctor’s name(s) with whom you intend to use the card and how you plan to use it. The other traditional information, such as date of birth, address, social security and net income will also be needed. Your application is then reviewed and your credit history and score are checked.

Healthcare credit cards can be used to cover deductibles, or pay for treatments and procedures not covered by insurance. Those might include dentistry, cosmetic, hearing, weight loss, vision, chiropractic, or some emergency situations. They work mostly like regular cards – you take a loan (the cost of the procedure or treatment) and pay it back over time. You need to research options carefully to ensure you are getting a good rate and even sufficient grace periods (where you don’t have to pay interest until a certain amount of time has elapsed).

Buyer beware! It’s the details in the agreement that can catch you off guard. Most medical credit cards operate on a deferred interest system which means if you don’t pay your entire bill within the specified time, you then owe interest on the entire amount. Additionally, there have been multiple news reports of consumer complaints and even government investigations into their use and application, including late penalties, and the inability to get refunded for procedures you never use.

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