by Scott K. Schmidt, Chief Financial Officer, U.S. Money Reserve
Managing your credit can be tricky. Here’s what you need to know.
Managing your credit can seem like a daunting task regardless of whether you are a seasoned expert or brand-new to it. That’s not necessarily because the rules of credit change per se, but because managing your credit takes some active participation and an understanding of how the whole credit system works — whether we’re talking about borrowing credit for a large purchase like a home or a vehicle or starting a business, or we’re talking about the kind of credit most of us use every day to make basic purchases. Here are the three credit mistakes you should never make and how to understand the way credit works, whether using it as an individual or as a business owner.
Understand the Basics of Credit.
First, it’s important to understand the basics of credit and how it works. A few core tenets apply whether you’re using credit for your personal life or using it for your small or large business. At its core, credit is a tool businesses and individuals can use to borrow money to make large purchases that they may not have cash on hand for. In turn, the borrower has to pay back the money on a set schedule that the creditor or lender determines. Most credit agreements include an interest rate, which is the rate that the borrower agrees to pay on top of the principal, which is the base amount they have borrowed on credit. Collecting the interest payments is how the lender makes money.
Understand the Types of Personal or Individual Credit.
There are several types of credit, but you really need to know the three main ones. These are installment, revolving, and open credit.
- Installment credit is the kind of credit you use to purchase a car or a home. This is a loan that is repaid at regular intervals with regular payments. You can think of an installment loan like a mortgage or a car payment. This type of loan or credit can last any length of time based on what your needs are. An installment credit loan typically has an end date and is closed once it is completely paid off. A business or an individual can take out an installment loan.
- Revolving credit is what you use on your credit cards, home equity lines of credit (or HELOC), and personal or business lines of credit. This kind of credit allows you to repeatedly borrow up to a set amount and pay it back over time. These types of credit accounts are generally open until you close them, regardless of how much or how little you owe on the accounts. The term “revolving” means that you can choose to pay the minimum each period and continue to revolve the debt forward over time. If you don’t pay the complete amount that you owe, you are charged an additional interest rate on the outstanding amount. The interest rate can be very high, and the debt can cost you much more than just the amount you owe. Both businesses and individuals can use revolving credit.
- Open credit allows you to make repeated payments to and withdrawals from an account at any time, but you have to pay the debt off completely in each period. This type of credit is similar to revolving credit in that you can take out as much cash as you need up to a set limit. However, this type of credit differs from revolving credit because you are required to pay it off completely at the end of the period, and you can’t revolve the debt forward like you can with credit cards. Open credit is frequently used by utility companies and gas, cable, and cell service companies. Both businesses and individuals have access to open credit.
Both individual consumers and businesses can open and use any one of these three types of credit or open and use multiple combinations of credit up to a limit.
Understand Different Types of Business Credit.
There are different types of credit that businesses can tap for different uses, in addition to those listed above, which are available to both individuals and businesses. These types of credit are only available to businesses and are limited as to what they can be used for. They include:
- Secured and unsecured lines of credit: These types of credit are used to purchase items like specialized equipment or to expand your business. Depending on the type of credit line you choose, you may need to provide collateral (like real estate, other equipment, or even future sales) or not in order to secure the loan. Lines of credit that require collateral are called secured lines of credit, and those that don’t require collateral are called unsecured lines of credit. Each type has many pros and cons, so it pays to talk to an expert and do your homework before you decide on the right line of credit for your business.
- Other varieties of loans and credit offers:
- Capital or start-up: Capital or start-up loans are credit accounts offered by lenders so that businesses can get their start. These kinds of loans can be used for everything from working capital to construction. Most of these loans can be found at the Small Business Administration, or SBA, and have very specific details regarding how they can be used. The SBA also offers an account called an SBA CAP line, which is a line of credit that can be used for capital.
- Equipment financing: This type of loan allows you to borrow to buy specific pieces of equipment that your business needs to create the goods it sells. This is a type of secured loan that is close-ended, much like a home mortgage loan.
- Invoice financing: This is a more complex credit offering than the other types of business loans. This credit gives business owners a way to borrow against their open invoices. Once customers pay their bills, those payments go directly to the lender to pay the debt, rather than back to the company. These are also close-ended loans.
How Credit Management Affects Your Credit Score (or Your Ability to Borrow)
The only limit to how much credit you can borrow, use, or open, is based on your business or individual credit score. A credit score is a measure of how creditworthy you are — and lenders and banks use the score as a way to determine how risky you or your business is as a borrower. Typically your credit score is determined by how you pay back your outstanding debts. If you pay on time, every time, and/or pay the full balance each time period, your credit score is likely to be high. If you miss payments, make late payments, or don’t pay the minimum balance when it is due, your credit score is likely to be low.
Individual credit scores range from 300 to 850, with 300 being very poor and 850 being excellent. Business credit scores range from 0 to 100, with 0 being very poor and 100 being excellent. Most lenders require a minimum credit score of 75 to loan to businesses. In both cases, the higher your credit score, the more you can borrow. Just remember that the more you borrow, the more you will have to pay back.
Other factors that affect your credit score include the length of time you’ve had credit and your credit usage. The longer you’ve had a credit history, the more likely banks and lenders are to extend you credit — especially if you’ve managed to keep it all in good standing over the years. Additionally, credit bureaus account for how much outstanding debt you have, which also determines how strong your credit score is. If you are maxing out your credit cards, loans, and other payment instruments every month, your credit score may fall — even if you pay your credit off in full each period. Creditors want to see that you are utilizing the credit they offer (because that’s how they make money), but they also want to make sure that you aren’t simply operating at the very top of the range all the time.
You can raise your credit score for both your personal accounts (known as your FICO score) and your business accounts by paying all of your bills on time, in full, every time they come due. You can also increase your credit score by making sure you have a long, accurate, and clean credit history and by using your credit wisely (and not overusing it).
Common Mistakes Businesses and Individuals Make When Managing Credit
Now that you understand the basics of credit, it’s time to talk about some of the most common credit mistakes both businesses and individuals make when it comes to managing it.
- Not Understanding the Terms
When you open a line of credit, regardless of whether you do so as an individual or as a business, you should be sure that you understand the terms you are signing up for. That means getting your head around the interest rate, payment deadlines, and credit limits, as well as the penalties for not paying on time, missing payments, or spending beyond your credit limit. You can find all these details in the paperwork you get when you open a line of credit. It pays to read the fine print and ask any questions about information you might not understand. Knowing what the requirements are when signing up for new credit is key to managing your credit well.
2. Not Checking Your Statement or Credit Report Regularly
We all get busy managing our lives, and we all forget to check our statements or our credit reports — but it is one of the main ways in which we fail to manage our credit. If you don’t know what’s happening on your statement or report, you can’t ensure that you actually make payments on time and manage your credit to keep your score as high as possible. It’s also helpful to regularly check your statement or credit report to make sure there aren’t any errors on it. The sooner you can catch a problem, the better equipped you are to start the process of repairing it.
3. Only Paying the Minimum Balance Each Month
Paying only the minimum balance each period doesn’t do you or your credit any good. If you’ve ever taken a close look at your personal credit card statement, you know that there’s often a note showing just how long it might take to pay off the balance if you only pay the minimum amount each period. In many cases, it can take years to pay off a balance if you only pay the minimum — and that doesn’t do your credit score any good. To best manage your credit, make sure you pay off your balances in full each month.
The Bottom Line on Intelligently Managing Your Credit
When it comes to managing your credit, it’s vital to get a good, solid understanding of what your obligations are. That means getting a handle on what credit is, what it can be used for, and how it works. It also means understanding the agreement, terms, and interest rates. To best manage your credit, you need to stay on top of it, monitor it regularly, and avoid common mistakes. If you practice good credit management, you’ll be sure to improve your credit score and have a long and prosperous financial life.