What is the Difference Between Good and Bad Credit?
It would be easy to assume that all credit is bad – I mean in all instances you’re borrowing money you cannot afford right now under the assurance that you will pay more than you borrowed to settle the loan.
However, not all reasons for borrowing money are necessarily bad; our modern society for better or worse is built on a foundation of credit and debt. Most, if not all, of the first world governments are fully invested in Keynesian Economics [http://en.wikipedia.org/wiki/Keynesian_economics] – the view that to stimulate growth especially in times of depression, spending needs to be encouraged, both consumer and government, and this is achieved by lending.
If the modern world is invested in a model of economics where growth is achieved through debt, then in the eyes of the governments and financial institutions, clearly not all credit can be bad.
What is good credit?
Governments borrow money from people and institutions in the form of bonds, and they use the money (hopefully) to build infrastructure that will help to expand the economy. This is an example of a good debt. Credit is obtained at a low interest rate that if the plan to grow the economy succeeds, will provide the country with a higher GDP, and the government with a larger increase in tax revenue than the interest on the bonds. The ROI is positive, and hence the credit was able to provide more growth than would have been possible without it.
That’s an example of good credit; money borrowed that would provide growth that wouldn’t be possible without it. A couple of examples of good credit for consumers are:
- student loans – the student is borrowing to invest in a higher paying job in the future
- mortgages – the value of houses as a general rule appreciates over time. A house can be a great investment and the value of the house is likely (in most cases) to far exceed the value of the loan by the time the loan is settled.
- business loans – it should be clear that if a business is successful, the value of the business could well be an order of magnitude higher than the amount of money initially borrowed
To highlight how good of an investment a mortgage is, the Federal Reserve Survey of Consumer Finances report [http://www.federalreserve.gov/pubs/bulletin/2012/pdf/scf12.pdf] lists the median net worth of a home owner in 2010 as $174,500, whereas the median net worth of a renter was only $5,100. This should be a sobering fact for anyone currently renting.
It should be realized that no loan is ever a guaranteed investment. The student could drop out of university, or simply take a lower paying job; the home owner might default on payments, and the house be repossessed to settle the loan; and the business may of course fail. However, although there is no guarantee that the credit will provide more value in the future, on balance it will.
So what is bad credit?
Well, bad credit is the opposite. Bad credit is borrowing money now that will provide no extra value after the debt is settled. The primary example of bad credit is credit card debt. Credit cards are usually used to pay for goods or consumables that the buyer cannot immediately afford. This sort of credit does not provide growth, and only serves to make the consumer more indebted than they were before.
Vehicle loans can also be seen as bad credit. While it is possible that a vehicle can be bought as an investment in yourself or your business, more frequently people borrow more than they need for a car that they want rather than require. A car is also not a good financial investment; depreciating on average 11% the moment it leaves the dealer, and an average of 15-25% each year over the next five years [http://www.edmunds.com/car-buying/how-fast-does-my-new-car-lose-value-infographic.html].
What effects do good and bad credit have on your credit score?
While good or bad credit doesn’t directly affect your credit score per se, maintaining a high utilisation of your debt to credit ratio for revolving credit (credit cards and the like), does. Debt to credit ratio accounts for 30% of your credit score, so keeping this as low as possible is essential to maintaining a good score. Although maintaining a high amount of bad credit on your account may well have an indirect negative impact on your credit score, more importantly it will affect lenders decisions. The credit score is used as a guideline, but decisions on loans, whether you will be able to borrow, how much, and at what rate will be based on the lenders interpretation of the contents of your complete report. Lenders are very likely to classify you more unfavourably if you have a high amount of bad credit on your credit report.
With this in mind, which debts should you pay off first?
It should be obvious that any bad credit should be settled before good credit is tackled. It might be tempting to pay off the student loan first rather than tackling the credit card bill that you let get out of control because of the psychological benefit you can envisage by clearing the debt (we all assume that we’ll have a credit card in some form or another throughout our life, however when a student loan is repaid, it is gone). However it would be far better to get the credit card to zero first, set up a payment to pay the balance on the credit card (so that it doesn’t get out of control again), and then tackle the student loan.
Settling accounts in this order is not only beneficial to your credit report, but also your monthly interest payments will be lower since your student loan will have a much better rate than your credit card.
In fact this holds true (for the most part) for all good and bad credit. Good credit will also come with a good interest rate, and bad credit will come with its own bad interest rate.
So clear down any bad credit account you may have before tackling your good credit accounts.
It’s worth mentioning at this point that credit card debt is not necessarily bad, and having a credit card can be beneficial to your credit score if used carefully. The long and the short of it being that you need to maintain a balance less than around 30% of your limit, and in general, as low as possible.
Is it a good idea to use good credit to settle bad credit accounts?
While on the face of it, it may seem prudent to use good credit to settle bad credit accounts, this is not necessarily the case. An example of using good credit to pay off bad credit would be taking a cash out refinance on your mortgage, and using the cash to pay off an out of control credit card account. Since the credit card has a bad interest rate, and the refinance on your mortgage carries a much better interest rate, then it may seem obvious that refinancing is the better option. However it depends.
Firstly a mortgage is over a very long term, and although the interest rate may be lower, you may in fact, over time pay more interest.
Far more importantly however is that it doesn’t tackle the issue of why you have so much bad credit in the first place. It does little more than brushing it under the carpet for the time being. If there is an unresolved issue with spending more than you have, no matter how determined you are to keep your debts under control after refinancing, the chances are that bad card debt will rear its head again.
When debt returns after having refinanced your mortgage, you are now in a worse situation than before; you again have a large amount of bad debt, but you have also lost equity in your home.
It might be more painful, but it is much better to deal with the credit card account in the traditional way since it may teach you some important lessons about money management and financial planning. Lessons that we really should all be taught in school.
That being said, if the reason for the bad debt is not out of control spending, and poor financial planning, and it’s not a situation that will just re-occur, then it can be prudent to take out good credit to pay off bad, but the specifics would be different from case to case, and so it’s something that you would need to discuss with a financial adviser.
Good credit is credit obtained to improve your financial wellbeing over time. Mortgages, business loans, and student loans are all prime examples of good credit. Bad credit is usually credit obtained with no investment value – credit obtained to pay for consumables, or items that will not appreciate in value over time. Primarily this is credit card debt, however it can take other forms.
Good credit will usually come with a lower interest rate than bad credit.
It is better to settle bad credit accounts first, and settle good credit accounts once a low level or zero bad credit is achieved.
It is also generally better to settle bad credit accounts rather than consolidating debt into a single low interest loan or mortgage refinance, however this is very dependent on the situation, so if you find yourself considering this, it is strongly advised that you seek the help of a qualified financial advisor.