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Credit Scores – The Importance of a Good Credit Score for Your Financial Future 

Stacey Walston 

Community Relationship Manager 

Bankable

Indiana

Lending is a decision that every consumer will need to make throughout their lifetime. Though it comes in many forms, credit is the lending tool that is factored in more often than not. It’s generally the beginning of any consumer’s financial journey and will determine their financial future as a buyer (consumer) and/or a seller (small business). 

Personal Credit

Just think about it. At the young and immature age of 18, young adults make decisions about their finances that can have a big impact on their financial future. Some may need to consider student loans to further their education. Meanwhile, the minute they get settled in on campus, companies are enticing them to sign up for credit cards by persuading them with free t-shirts or slices of pizza. Most times they don’t know what credit cards are nor have they ever been taught how to utilize them properly. 

The same thing happens to small business owners when they set out to launch their business model. Since the rise of the Great Resignation, access to funding sources has been at an all-time high for entrepreneurs. Even with a solid business plan in place, most entrepreneurs don’t consider the personal credit profile they will need to secure the capital needed to fulfill their current and forecasting business goals. With the lack of guidance or the inaccurate research discovered, most entrepreneurs assume it starts with their business credit but how they have managed their credit in the past is the asset that is most considered. 

Working within the supporting side of the entrepreneurship ecosystem, I’ve seen firsthand how great business models fail or fail to launch at all because of one’s poor personal credit. Credit determines one’s purchasing power by how it’s managed over time and can leverage opportunities for small business owners. Entrepreneurs need to take action before needing capital to understand the expectations and how to best prepare them for reaching their business goals.

Understanding & Building Your Credit

When lenders talk about credit, they mean your credit history. Your credit history describes how you’ve used money and handled your bills in the past. This helps lenders decide if they want to do business with you and use certain criteria to evaluate borrowers before issuing debt. The criteria often fall into several categories and are referred to as the five Cs of credit. Though debt comes in many forms; a line of credit, a credit card, or a term loan, your credit is determined, considered, and dissected based on the borrower’s character, capacity, capital, collateral, and conditions. 

Lenders use the five Cs to decide whether a loan applicant is eligible for credit and to determine related interest rates and credit limits. They help determine the riskiness of a borrower or the likelihood that the loan’s principal and interest will be repaid in a full and timely manner. To ensure the best credit terms, lenders must consider their credit character, capacity to make payments, collateral on hand, capital available for up-front deposits, and conditions prevalent in the market.

The 5 Cs of Credit

Character, the first C, makes up 35% of your credit score. It more specifically refers to your credit history, which is the borrower’s track record of repaying debts according to the agreed terms. Most alternative lenders consider one’s character more important than one’s actual credit score. 

Capacity makes up 30% of your credit score. It measures the borrower’s ability to repay the loan by comparing income against recurring debts and assessing the borrower’s debt-to-income (DTI) ratio. Lenders calculate DTI by adding a borrower’s total monthly debt payments and dividing that by the borrower’s gross monthly income. Every lender is different, but many mortgage lenders prefer an applicant’s DTI to be around between 28-36% before approving an application for new financing. The lower an applicant’s DTI, the better the chance of qualifying for a new loan. Having credit accounts and owing money on them does not necessarily mean you are a high-risk borrower with a low score. However, if you are using a lot of your available credit, this may indicate that you are overextended—and banks can interpret this to mean that you are at a higher risk of default. It is worth noting that sometimes lenders are prohibited from issuing loans to consumers with higher DTIs.

Capital is money that the borrower puts toward a potential investment. A large capital contribution by the borrower decreases the chance of default through the lens of a lender. Borrowers who put money down typically find it easier to secure funding. Capital contributions indicate the borrower’s level of investment, which can make lenders more comfortable about extending credit. Capital contributions can also affect the rates and terms of a borrower’s loan. Generally, larger down payments and capital contributions result in better rates and terms.

Collateral can help a borrower secure a loan. It assures the lender that if the borrower defaults on the loan, the lender can get something back by repossessing the collateral. Collateral is usually in the form of an asset such as a vehicle, real estate, or equipment purchased. Collateral-backed loans are sometimes referred to as secured loans or secured debt. They are generally considered to be less risky for lenders to issue. 

In addition to the four of the five Cs already mentioned, lenders look at the general Conditions relating to the loan. 

Conditions may include the length of time that an applicant has been employed at their current job, how the industry that the business is categorized as is performing, and the future job stability or longevity of the small business at hand.  The conditions of the loan, such as the interest rate and the amount of principal, influence the lender’s desire to finance the borrower. Conditions can refer to how a borrower intends to use the money like entrepreneurs acquiring a business loan that may provide future cash flow. Additionally, lenders may consider conditions outside of the borrower’s control, such as the state of the economy, industry trends, or pending legislative changes. For small businesses wanting to secure a loan, these uncontrollable conditions may be the prospects of key suppliers or their target market’s financial security in the coming years.

Each of the five Cs has its value, and each should be considered important but character and capacity, which are the most heavily weighted, are often most important for determining whether a lender will extend credit. Some lenders may carry more weight for categories than others based on prevailing circumstances.

Credit Reports

All the information previously mentioned appears on a borrower’s credit report, which is generated by the three major credit bureaus: Equifax, Experian, and TransUnion. Credit reports contain detailed information about how much an applicant has borrowed in the past and whether they have repaid loans on time. The information found on one’s credit report creates their credit score, a tool that lenders use for a quick snapshot of creditworthiness before looking at credit reports.

FICO Scores range from 300 to 850 and are designed to help lenders predict the likelihood that an applicant will repay a loan on time. Other firms, such as Vantage Score, a scoring system created by a collaboration of Equifax, Experian, and TransUnion, also provide information to lenders.

Many lenders have a minimum credit score requirement before an applicant is approved for a new loan. Minimum credit score requirements generally vary from lender to lender and from one loan product to the next. The higher your credit score, not only the likelihood of a borrower’s credit being approved but the less expense it’s going to be for them to borrow. Lenders regularly rely on credit scores to set the rates and terms of loans. The result is often more attractive loan offers for borrowers who have good to excellent credit. 

Having already discussed 65% of how one’s score is calculated (35% credit history & 30% amounts owed), let’s discuss the remaining 35%.

Length of Credit History makes up 15% of your credit score. Having a longer credit history is positive for your credit score but is not required for a good credit score. Your scores consider:

  • How long your credit accounts have been established, including the age of your oldest account, the age of your newest account, and the average age of all your accounts?
  • How long specific credit accounts have been established?
  • How long it has been since you used certain accounts?

New Credit makes up 10% of your credit score. Research shows that opening several credit accounts in a short amount of time represents a greater risk—especially for people who don’t have a long credit history. Inquiries remain on your credit report for two years. FICO Scores only consider inquiries from the last 12 months.

Credit Mix makes up 10% of your credit score. FICO Scores will consider your mix of credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. Don’t worry, it’s not necessary to have one of each. Creditors assess the risk of lending money through a variety of factors, one of them being your ability to successfully manage different types of credit.

Other credit scores or FICO Scores?

While FICO Scores are used by 90% of top lenders, there are other credit scores made available to consumers. Other credit scores may evaluate your credit report differently than FICO Scores. When purchasing a credit score for yourself, most experts recommend getting a FICO Score, as FICO Scores are used in 90% of lending decisions.

An important takeaway is that credit is key for both consumers and small business owners as it determines their financial destiny. The journey starts early with that first credit card or student loan and continues through the entrepreneurial ventures of small business owners. Your credit profile is the foundation, it determines your ability to get capital and achieve your business goals. The 5 Cs of credit—character, capacity, capital, collateral, and conditions—give you a framework to evaluate creditworthiness. Each one contributes to your credit score and overall financial health, loan eligibility, interest rates, and terms. And to build and maintain good credit you need to have a healthy credit report, know the components of a credit score, and see the importance of credit history, new credit, and credit mix.

Credit management is an ongoing process that requires education, awareness, and planning. Taking care of your credit can increase your financial stability and unlock new opportunities. Credit knowledge is key to long-term success, whether in personal finance or business.

Research: Investopedia, My Fico

Community Relationship Manager at Bankable

Naptown native, Stacey Vernee' Walston is a born entrepreneur with a wealth of experience working in and supporting Indy's entrepreneurship ecosystem for over 20 years. She previously served as the Financial Coach for the Indianapolis Urban League (IUL) and during that time she developed a passion for teaching financial literacy and coaching individuals toward financial stability. Utilizing the financial skills, she developed as a single mother, small business owner, and financial coach, she founded First Things First, a coaching platform that assists individuals towards financial independence and empowerment.

After serving as the Financial Coach at IUL for 3 years, Stacey was promoted to launch their Entrepreneurship Center Program (ECP). She developed a curriculum geared towards assisting entrepreneurs with developing, launching, sustaining, and growing minority small businesses in central Indiana and surrounding counties. She now serves as a Community Relationship Manager for Bankable. A role where she connects entrepreneurs to capital to grow their businesses alongside serving within the entrepreneurship ecosystem as a financial and business coach.

 

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