Debt-To-Income Ratio - Why it's Just As Important As Your ...
Credit Overview, DTI, and Credit Terms
Mr. Stewart’s Economics Class
Spring Semester 2021
Review for Credit Quiz
What is credit?
Credit is borrowed money that you can use to purchase goods and services when you need them. You get credit from a credit grantor, whom you agree to pay back the amount you spent, plus applicable finance charges, at an agreed-upon time.
There are four types of credit:
1. Revolving credit. With revolving credit, you are given a maximum credit limit, and you can make charges up to that limit. Each month, you carry a balance (or revolve the debt) and make a payment. Most credit cards are a form of revolving credit.
2. Charge cards. While they often look like revolving credit cards and are used in the same way, charge accounts differ in that you must pay the total balance every month.
3. Service credit. Your agreements with service providers are all credit arrangements. You receive electricity, cellular phone service, gym membership, etc., with the agreement that you will pay for them each month. Not all service accounts are reported in your credit history.
4. Installment credit. With installment credit, a creditor loans you a specific amount of money, and you agree to repay the money and interest in regular installments of a fixed amount over a set period of time. Car loans and mortgages are two examples of installment credit.
Why Do You Need Credit?
Good credit is necessary if you plan to use credit to make a major purchase, such as a car or a home, or want to be able to take advantage of the convenience credit can provide. The importance of good credit also extends beyond purchases, in that your credit information may be used by potential employers and landlords as part of the selection process.
Credit grantors review credit applications and credit reports to determine financial risk: If they lend you money, extend you credit or give you goods and services, will you pay them back? They may consider your income, how long you’ve lived at your present address, how long you’ve worked for the same employer, what kinds of assets you have and the balances of your bank accounts. Often, though, the primary resource guiding their decision is your credit information.
The Risks and Rewards of Using Credit
Your credit record reflects how well you managed your financial responsibilities over a certain period of time. Obviously, there are rewards for handling your credit well. Having a good credit report can give you the ability to:
• Improve your lifestyle through purchases that are only possible with credit
• Utilize services that are only available if you have a credit card — for example, renting a car
• Have the resources to pay for unexpected emergencies
However, there are risks involved with credit. Poorly managed credit can land you deeply in debt, and recovery is not easy. You can’t restore a good credit history overnight, but you can improve your credit record over time.
The Rules of Credit
The rules of credit are few and simple. A lender extends you a line of credit. You agree to pay the lender back the amount you spend plus finance charges and perhaps additional service fees. A payment schedule is set up, and you are required to make payments according to that schedule. The most important advice is to pay your bills on time.
Using Credit for the First Time
Getting your first line of credit sometimes can be challenging. If you don’t have a credit history, or if your report has a serious blemish like bankruptcy, lenders may be reluctant to extend you credit. You may want to talk to a local department store or bank. Ask if they will open a line of credit for you for perhaps only $200 or $300.
It may be necessary to have a parent or friend with a strong credit history cosign for you. If a person cosigns on your behalf, he or she is accepting equal responsibility for the loan or credit line. Without someone to cosign, you may need to begin with a secured line of credit. To do so, you must open an account with a bank or other lending institution. In turn, you will receive a line of credit with a limit equal to a percentage of your bank account balance. Often, this type of credit has higher interest rates and fees, but it may be a good way to get your first credit card.
• Set up a budget and stick to it. You need to be aware of how much debt you already have and how much you are adding to that debt by buying with credit.
• Shop around for credit. Lower interest rates, lower or no annual fees, cheaper service charges and additional benefits such as frequent-flier miles or special insurance rates are available. Find the credit that is right for you.
• Once you have signed a credit agreement, you are responsible for it unless the creditor agrees to release you from the agreement. That not only includes credit cards and installment loans, but also health club agreements and cellular telephone contracts, even if you stop using the service. Remember also that a divorce decree does not release you from responsibility for joint accounts.
• Protect yourself from credit fraud. Treat your credit cards like cash. Sign them as soon as you get them. Don’t leave them lying around. Shred receipts that have your account number on them, and do the same with credit offers you receive in the mail but choose not to accept.
Tips for Using Credit
When you are extended a line of credit, use it, but use it carefully. Be certain your account is reported to a credit-reporting agency. Most importantly, make your payments on time.
Look over your credit report once a year. Reviewing your report will ensure that your accounts are being reported correctly.
Debt-To-Income Ratio
Your debt-to-income ratio (DTI) is a simple way of calculating how much of your monthly income goes toward debt payments. Lenders use the DTI to determine how much money they can safely loan you toward a home purchase or mortgage refinancing. Everyone knows that their credit score is an important factor in qualifying for a loan. But in reality, the DTI is every bit as important as the credit score.
What is Income?
Income is the total revenue which you earn during a given time period. This income includes not only your salary, but also returns on any investments, and interests you earn on your bank accounts, etc.
What is Debt?
Debt is the money that you owe on a loan or credit cards. Debt can be classified as either short-term debt or long-term debt. Short-term debt is like a credit card bill or an overdrawn bank account. These debts are incurred and fully paid off on a periodic basis. Then there are long term debts like a home loan and a car loan on which you pay over a longer period of time. You pay the mortgage amount every month for a number of years to service this long-term debt.
Glossary of Credit Card Terms
Annual Fee: A fee that is charged once a year for a credit card account.
Annual Percentage Rate (APR): The yearly rate of interest on a credit card account, expressed as a percentage.
Bankrupt: The status of being legally declared unable to pay your debts as they become due. Federal bankruptcy laws have been enacted that allow a person or organization to liquidate their assets to pay a reduced amount to their creditors or that allow the rehabilitation of the debtor by requiring creditors to accept reduced payments from future earnings of the debtor. A declaration of bankruptcy will remain on a person's credit report from 7 to 10 years and, in some cases, indefinitely. Declaring bankruptcy is generally considered a last resort.
Billing Cycle: The length of time between billing statements.
Charge Card: Unlike revolving credit card accounts, which allow you to carry balances from month to month, charge card accounts must be paid in full every month.
Credit Card: A plastic card issued by a bank or other financial company for the purpose of purchasing goods and services using credit. In most cases, a credit limit is established for each account.
Credit Line: The most you can charge on your credit card account. When you receive a new credit card, you're usually issued a set credit line. Under some circumstances, your card issuer may increase or decrease it.
Credit Report: The record of your credit history. It shows whether you pay your bills on time, how much debt you have, and the like. Your report is compiled by credit reporting agencies and released to lenders and others. You may order a free credit report every year from the three major credit bureaus. See "Credit Reporting Agencies".
Credit Reporting Agencies: Credit reporting agencies collect and report vital facts about your financial habits, for instance, whether or not you pay your bills on time. These facts are then compiled into a "credit report," which can be accessed by potential creditors, employers, and the like. The three major credit reporting agencies are Equifax, Experian and TransUnion. You can contact them at the addresses below.
|Equifax | |Experian | |TransUnion |
| | | | | |
Debit Card: This enhanced ATM card subtracts money from your deposit account when you use it to make a purchase or get cash.
Grace Period: If you have a credit card, the period of time the issuer doesn't charge interest on purchases. Be sure to read the fine print; Some credit card issuers give a grace period only if the account is paid up and doesn't have a balance carried over from the previous month.
Interest Rate: A rate of interest charged for the use of a credit card, loan or line of credit, expressed as a percentage of the total amount loaned. Different types of loans charge different rates of interest.
Interest Charges: The sum of interest on your credit card account, and it is broken down by transaction type: purchases, cash advances, and balance transfers.
Introductory APR: A temporary, usually low, interest rate (expressed as an annual percentage rate) offered by providers to "introduce" you to their services. It will usually expire after a certain amount of time and may also be terminated based on your behavior, such as if you make late payments. Be sure to check the details of the offer for any limitations on an introductory APR.
LIBOR (London interbank offered rates): Five major London banks determine these fixed rates daily for specific maturities. What does this mean to you? LIBOR may be used by some banks instead of the Prime Rate to set APRs.
Minimum Payment: Shown on your credit card statement, the lowest amount you can pay every month, based on that month's balance at the time of billing.
Non-Variable APR: Unlike a "variable APR," this type of APR does not automatically fluctuate based on changes in an index such as Prime Rate or LIBOR. A "fixed APR" does not mean that the rate is guaranteed not to change, though. Refer to your account terms for information on your issuer's ability to change the APR on your account.
Prime Rate: A "base" rate some financial institutions use to set the APR of credit cards and loans.
Principal: Unlike interest or fees, the principal reflects the actual dollar amount of the purchases you made or the balance that remains on your loan or credit card account.
Secured Card: A great "first credit card" or way to reestablish your credit rating, this kind of card is "secured" by money you deposit in a designated savings account. For instance, if you deposit $500, your credit card limit generally will be for that amount. If for some reason you cannot pay your credit card bills, your credit card issuer will be paid from the savings account.
Variable APR: The variable APR (expressed in yearly terms) fluctuates based on an index, such as the Prime Rate or LIBOR.
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