Give credit where credit is due: Basics of credit

Credit mini-series part 1

Credit is one of the most important concepts in finance. Everyone and their mother will have credit at some stage of their lives. It affects you when you want to buy a house, a car, start a business, take out a new cell phone contract or even open an Edgars account. In this series, we discuss all-things credit in three articles: The basics of credit, advantages of a good credit, and improving your credit score. Lets start with the first: The basics of credit.

What is credit?

Credit has been around for about 3000 years. Is has drastically influenced how we operate as a species, especially in modern times. There are various types of debt that one can acquire, such as student loans, home loans, vehicle loans, small business loans, credit cards, cell phone contracts etc. Basically, any purchase that you dont or cant pay in full, represents a loan. 

Why do banks lend money?

Credit is a facility given to a borrower in the present, based on the trust that the borrower will repay the facility in the future. The lenders incentive to loan money comes in the form of charging interest, meaning the borrower will pay the initial amount plus interest incurred over the duration of the loan. This is the business model of a bank: Loan money in order to earn interest. If this is the business of the bank, it is essential that they lend only to people whom they believe will repay the money. This is where credit scores come into play.

What is a credit score? 

Credit scoring is a statistical analysis to determine the creditworthiness of a person. In simple terms, a credit score is a numerical measure of how good of an idea it is to loan you money. Lenders and financial institutions use credit scores to evaluate the probability that an individual will repay their loans in a timely manner. 

Factors in a credit score

Your credit score is calculated by five different inputs, each with its own weighting.

1. Payment history (35%): How timely you made your payments in the past is a pretty good indicator of how you will make your payments in the future. Payment history is the most important contributor in a credit score.

2. Amounts owed (30%): This indicator determines your capacity to take on new credit. It calculates the percentage of your monthly income that is already committed to debt payments (called the debt-to-income ratio). The lower your current debt, the better your chances of qualifying for additional credit. 

3. Length of credit (15%): This is a track record of your long-term relationships with institutions. Successfully managing your credit over the longer-term shows that you can reliably handle your financial obligations.

4. New credit (10%): Taking on too much new credit signals potential irresponsible spending. There is a risk is associated with consumers who have multiple recent account inquiries.

5. Credit mix (10%): Credit mix refers to the different types of credit, such as home loans, vehicle financing and credit cards. Managing various types of credit are determined to be less risky than having only a single type of credit facility.

Who tracks your credit?

Your credit score and credit report are calculated and compiled by credit bureaus. The four major credit bureaus in South Africa are Experian, TransUnion, Compuscan, and XDS. These bureaus assess individuals in various areas of credit and supply this information to banks and other financial institutions.

Calculating your credit score

Though there are various models available to calculate ones credit score, FICO is the most common. Its scores range between 300 and 800, with 650 and upwards qualifying as good or great credit scores. You can receive a free credit score via Experian or ClearScore by using the following links:

https://www.mycreditcheck.co.za/

https://www.clearscore.com/za

Give credit where credit is due, part 2

Congrats! You now understand the basics of credit scores and we have received the results of your very own credit score. In the next article, Give credit where credit is due, part 2, we will discuss tips to improve your credit score.