What Is Credit?

On a recent cross country flight, a fellow passenger -- PhD in mechanical engineering, former senior executive, who now solves manufacturing problems for companies throughout the world -- said, "I'm not sure I know what credit is." It's a comment I've heard many times since morphing into a credit wonk. However, when he said it I wondered how many people think credit is mumbo-jumbo jargon and don't ask?

Credit, as when someone says, "I have good credit," whether it's personal or for your business, is an evaluation of how debt has been managed.

When a merchant or financial institution opens an account for you or your business, or you borrow money to go to school, purchase a car, expand your company, buy a house, or for any other reason, the lender has extended credit to you. When you accept the credit you assume any debt that accrues through your use of the account.

There are two types of debt: secured and unsecured. Secured debt requires collateral to back up, or secure, the loan. This can be a car for an auto loan, a house for a mortgage or home equity loan, and other valuable assets that a lender will accept as back up for a personal or business loan. When a lender requires collateral, a lien is attached to the property used to guarantee the loan. If you default on (don't pay) the debt, the lender can take the asset used to secure the loan and sell it to pay your debt. Some of the paintings auctioned at Christie's, New York, Spring Impressionist sale were assets used to secure hedge fund positions.

Unsecured loans, such as credit card accounts and personal loans (sometimes called signature loans) do not require collateral. The lender assumes greater risk when they extend credit through unsecured loans. This is the reason people with excellent credit histories receive interest rates that are much lower than borrowers with low credit scores. As financial institutions have experienced credit crunches resulting from lost income due to foreclosed mortgages, credit card lending practices have grown more stringent to reduce their unsecured risk.

The way you use the credit that is extended to you creates your credit history.

    * Do you pay on time? With business credit, your credit score increases by paying early. (See the Dun & Bradstreet Paydex Value Table.) Unfortunately, individuals don't get any gold stars on their credit reports for early payment.
    * Do you use a small percentage of the credit limit available on each account? Or do you max out your charge accounts? As an individual, to increase your credit scores you need to use no more than 10 percent of the limit on any account (see my column, Caution: Stay Well Below Your Credit Limit) and pay it off each month or within a couple of months. Making minimum payments will not drive your credit scores higher. Using more than 40 to 50 percent of an account limit will lower your credit scores. With business accounts, which are not reported on your personal credit reports, there are no constraints to the amount of credit you can use. You will not experience any negative repercussions on your business credit report by using your available credit and paying it off on time.
    * Do you have your credit checked frequently and open an account with every 10 percent discount offer on a department store purchase? As an individual, your credit scores get dinged every time your credit is checked (see my column, How to Raise Your Credit Scores Immediately) and having an excessive number of open accounts with balances will decrease your credit ratings. However, businesses do not take a hit when credit is verified. In addition, you can have many open accounts for your business as long as you pay them on time.

When you manage your accounts prudently lenders consider you an excellent credit risk. Manage them sloppily and you will become a high-risk borrower who pays much higher interest rates or is denied credit.

The good news about a messy credit history: You can clean it up and rebuild your credit life. (See my column, You Can Build Excellent Credit.)

If your credit is excellent, it's important to understand why so you don't make decisions, such as closing several old accounts and combining those balances into one new maxed out low interest account, that could cause your credit scores to nosedive by 100 to 150 points.

During this period of more conservative lending practices, it is essential to take control of your debt, manage it diligently, and reap the rewards that come with excellent credit.