NATURE OF CREDIT

Credit
is the trust which allows one party to provide money or resources to another party wherein the
second party does not reimburse the first party immediately, but promises either to repay or
return those resources at a later date.

ELEMENTS AND FOUNDATION OF CREDIT

The Three C’s of Credit

Your credit score is a measure of factors that may affect your ability to repay credit. It’s a
complex formula that takes into account how you’ve repaid previous loans, any outstanding
debt, and your current salary.
A credit score is dynamic and can change positively or negatively depending upon how much
debt you accrue and how you manage your bills. The factors that determine your credit score
are called The Three C’s of Credit - Character, Capital and Capacity. These are areas a creditor
looks at prior to making a decision about whether to take you on as a borrower.

Character
From your credit history, the lender attempts to determine if you possess the honesty and
reliability to repay the debt.
In pursuit of that assessment, they might ask the following questions:
 Have you used credit before?
Do you pay your bills on time?
Do you have a good credit report?
Can you provide character references?
How long have you lived at your present address?
How long have you been at your present job?

Capital
The lender will want to know if you have any valuable assets such as real estate, personal
property like an automobile, or savings and investments that could be used to repay credit
debts if income is unavailable.
They might ask these questions with regard to capital:
What property do you own that can secure the loan?
Do you have a savings account?
Do you have investments to use as collateral?

Capacity
This refers to your ability to repay the debt. The lender will look to see if you have been
working regularly in an occupation that is likely to provide enough income to support your
credit use.
The following questions will help the lender determine this:
Do you have a steady job? If so, what is your salary?
How many other loan payments do you have?
What are your current living expenses?
What are your current debts?
How many dependents do you have?

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What Are the 5 C's of Credit?

The five C's of credit is a system used by lenders to gauge the creditworthiness of potential
borrowers. The system weighs five characteristics of the borrower and conditions of the loan,
attempting to estimate the chance of default and, consequently, the risk of a financial loss for
the lender.
1. Character
Although it's called character, the first C more specifically refers to credit history, which is a
borrower's reputation or track record for repaying debts.
2. Capacity
Capacity measures the borrower's ability to repay a 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. The lower an applicant's DTI, the better the chance of qualifying for a new loan. Every
lender is different, but many lenders prefer an applicant's DTI to be around 35% or less before
approving an application for new financing.
3. Capital
Lenders also consider any capital the borrower puts toward a potential investment. A large
contribution by the borrower decreases the chance of default. Borrowers who can put a down
payment on a home, for example, typically find it easier to receive a mortgage. Even special
mortgages designed to make homeownership accessible to more people, such as loans
guaranteed by the Federal Housing Administration (FHA) and the U.S. Department of Veterans
Affairs (VA), may require borrowers to put down 3.5% or higher on their homes.
Down payments indicate the borrower's level of seriousness, which can make lenders more
comfortable extending credit.
Down payment size can also affect the rates and terms of a borrower's loan. Generally
speaking, larger down payments result in better rates and terms. With mortgage loans, for
example, a down payment of 20% or more should help a borrower avoid the requirement to
purchase additional private mortgage insurance (PMI).
 4. Collateral
Collateral can help a borrower secure loans. It gives the lender the assurance that if the
borrower defaults on the loan, the lender can get something back by repossessing the
collateral. The collateral is often the object one is borrowing the money for: Auto loans, for
instance, are secured by cars, and mortgages are secured by homes.
For this reason, 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. As a result, loans that
are secured by some form of collateral are commonly offered with lower interest rates and
better terms compared to other unsecured forms of financing.

5. Conditions
In addition to examining income, lenders look at the length of time an applicant has been
employed at their current job and future job stability.

Why Are the 5 C's Important?

Lenders use the five C's 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.

The Pros And Cons Of Credit Cards

Credit cards are often seen as a rite of passage for the financially independent—especially
among young adults. Today, there’s no shortage of options available to those who want to
borrow funds, whether it’s for a specific purchase, to supplement income between pay periods,
or to get a small business off the ground.
Because of the many advantages credit cards offer over cash and debit cards, it’s not surprising
that they’ve become one of the most popular payment methods among consumers. Of course,
credit cards also present certain challenges when not used responsibly, which helps explain
why the average American has a credit card balance of $6,375, according to Experian's annual
study on the state of credit debt in America.
Credit cards can be a great addition to your day-to-day financial plan. However, before opening
multiple cards, consider some of the pros and cons:
 Pro: They’re a Great Way to Build Credit
Your credit history is your track record of borrowing money and paying it back. Each time you
open a new credit card account, the lender reports that activity to a credit reporting agency.
They’ll also report if you miss a payment or are frequently late paying your monthly
installments. Your credit history determines your credit score, which ultimately lets lenders
know whether you’re a good candidate for a credit card or loan and which parameters to assign
you (i.e., your interest rate and credit limit). Good credit can improve the quality of your life
and get you closer to your financial goals if used responsibly.

Con: High Cost of Borrowing

Although credit cards are convenient, the cost of borrowing is typically much higher than with a
traditional loan.  Many come with high APRs (the annual interest rate charged on borrowed
funds), service fees, and penalties for late payments. If you don’t pay your balance off every
month, these additional finance charges can quickly grow your existing debt. Additionally, many
credit cards allow you to get a cash advance if you need cash quickly—but the interest rate
charged on these advances is typically even higher than for purchases.

Pro: They’re More Secure Than Cash

Credit cards are used frequently—even by people who have access to cash—because they offer
another level of security. If you lose a credit card or someone steals your information, the credit
card company can place a hold on it to avoid fraudulent purchases. Additionally, many credit
card companies monitor suspicious activity and will notify you if something seems inconsistent
with your typical spending behavior.

Con: It’s Easy to Dig Yourself into a Hole

Depending on your credit limit, a new credit card may suddenly give you access to more funds
than you’ve had in the past, making it easy to overspend if you are not disciplined. To avoid
digging yourself into a hole and potentially damaging your credit and financial health, it’s
important to only spend what you can reasonably afford to pay back each month. If you don’t
already have a budget, making one can help you stay on track, so you don’t accumulate too
much debt.

Pro: Rewards Points

Many credit card companies offer rewards such as cash back or airline miles for using them
regularly. If you use a credit card for routine expenses, these rewards can add up quickly.
Though many rewards cards come with annual fees, the benefits you can accrue over the
 course of a year can more than offset the cost of keeping the card open.

Con: Applying for Too Many Credit Cards Can Damage Your Credit
Several factors impact your credit score, including payment history, current amount owed,
length of history, new credit, and types of credit used. While having a few cards that you use
regularly and pay back on time can help you build and improve your credit, there’s a limit to
how many cards you should reasonably open. Each time you apply for a new credit card
account, lenders can check your credit report to assess your credit worthiness. Not only can too
many card applications negatively impact your credit score, lenders may get suspicious if it
looks like you need access to a lot of credit and reject your application.
Realistically, nearly everyone needs to borrow money at some point to achieve their financial
goals. Credit cards are a great way to bridge the gap between paychecks or finance large
purchases that you can pay off over time. However, when used irresponsibly, credit cards can
quickly erode your credit and financial health. Therefore, it’s important to consider all the
advantages and disadvantages before incorporating credit cards into your financial plan.