A Tale of two Credits

“It was the best of times, it was the worst of times.”

Charles Dickens reminds us that even in the 21st century, we live in a world where radical opposites take place at the same time. The realities of the credit system are no different. Credit is one of the main drivers of wealth in the United States. The interest rate on a mortgage, for example, is partially dependent on a customer's credit score. And it's no surprise that it is -a good mortgage can go a long way. Bloomberg reported that home ownership had reached a milestone in the U.S. as of August 2022, "with nearly half of mortgaged properties being considered equity-rich (meaning owners had at least 50% in home equity)." A mortgage, at its core, is a type of credit extended to allow for the purchase of a home, with the property itself serving as collateral for the loan (if you don't pay the mortgage back, the bank is entitled to take your home). As the value of these homes rises, the mortgage or "debt" portion stays fixed, allowing the "equity" portion - the owner's accumulated wealth - to rise. Having access to a credit product like a mortgage has been the bread and butter of wealth creation in America. Yet the power of credit can have a darker side. I recently sat down with my dad to talk about his own history with credit. Even after 10 years in Los Angeles across multiple job functions (dishwasher, janitor, truck driver), it was only when he moved to New York and at the pressure of his younger sister that he decided to open his first credit card. My dad lost 10 years of credit history in the United States because he wasn't exposed to conversations around its importance. Fast forward 10 years later and the situation has turned a different shade of grey. My dad has finally opened a credit card; however, he hasn't just opened one - he has opened eight and is now sitting on $15,000 of credit card debt.

Growing up in a Latino household, conversations around debt and credit were "hush-hush" - it was a private, personal topic that couldn't be brought up in conversation with other family or friends. When we did speak about credit, the discussion wasn't about building a good score to secure a non-predatory mortgage down the line. Rather, when we were strapped for cash, my parents would cave in to the department sales associate who promised a 20% discount on our order for opening a new retail store credit account. In that moment, it didn't matter that the new Old Navy credit card had a daily compounded APR of 25.99% (60% above the national average 3Q22 average of 16.27%). My parents only saw the relief of the extra discount - the worries of paying off that debt (and its interest) would come later.

Unfortunately, this cycle is far too common, especially among low-income families. But change begins with small steps that build over time. To that extent, I share below 4 main credit insights I think the every day user should know before embarking on their credit journey.

1/ The Credit Card Rating Agencies

There are three main credit card rating agencies - Equifax, Experian, and TransUnion. These agencies assign all credit users a "credit score" which rates their ability to make timely payments (among others things). Banks and financial institutions use this credit score to gauge a customer's likelihood of default. The score these credit rating agencies assign ranges from 300 - 850 (the higher the better). Do you know what your credit score is? If not, you can (1) get a free credit report from your credit card issuing bank or (2) download the Credit Karma app.

2/ The Credit Score Formula

Now that we know who determines your credit score, let's talk about how they get there. This section details how the three credit rating agencies arrive to your score. 1/ Payment History (35%) - have you always paid your statement balance on time? Make sure you have a consistent history of not missing payments - it's the largest portion of your score!

2/ Credit Utilization/Amounts Owed (30%) - you want to be in the sweet spot of <10% credit utilization. If your credit line is 1,000 and your statement balance comes at 600, your utilization rate is 60% - no bueno. Try to keep this numbers low (tip: make a payment before the end of your billing cycle).

3/ Length of Credit History (15%) - how long have you had a history of credit for? The longer the better. Yes, this means younger users will naturally start with lower credit scores as they need to build their history. Don't worry about this, just give it time.

4/ Credit Mix (10%) - there are three types of credit: a) revolving credit - think credit card; b) installment credit - think your student loan or mortgage; c) open credit - think your utility bill. Having a good mix of all three can help boost your score.

5/ New Credit (10%) - every time you apply for a credit card, you will have a "hard inquiry" conducted. Try to limit how frequently you open a credit card. Having 2-3 is ideal. If you open 8 different credit cards, you will have 8 hard inquiries, which will dent your credit score.

3/ The Credit Card Calendar

There are two key dates you should keep in mind when dealing with credit cards: 1/ billing cycle end date and 2/ statement due date.

The billing cycle will usually be 28-30 days. For example, your billing cycle can be from June 3 - July 2. It is the amount of credit you use during this time that determines your eventual bill (+ any balances/interest rolled over from previous months). You should remember when the end of your billing cycle is, as it is not always the end of the month. Purchases made after your statement billing cycle will be reflected on the next month's statement.

The statement due date is when you must actually pay for the purchases during your billing cycle. This date usually occurs 20 days after the close of your billing cycle. This 20-day gap is known as the grace period. In our previous example, the due date for the June 3 - July 2 billing cycle could be July 22. That is, assuming no carried over balances, on July 22nd you must pay what you owe from spending during the June 3 - July 2 period.

4/ The Credit Card Compound Interest

Using a credit card comes at the risk of collecting large amounts of interest if your balance is not paid in full. The rate charged to any outstanding debt is known as the Annual Percentage Rate (or APR). It is worth noting that APR does not take into account the compounding of interest within a specific year. The credit card issuing cards do this on purpose, without indicating how many times the rate is applied to the balance.

APR is calculated as follows:

APR = Periodic Rate x Number of Periods in a Year Let's assume a credit card company charges 1% interest each month. The APR from this interest schedule is 12% (1% x 12 months = 12%) as it is annualizing the monthly interest. This number is different from APY, which takes into account compound interest.

APY is calculated as follows: APY = (1 + Periodic Rate)^ Number of periods – 1 The APY for a 1% rate of interest compounded monthly would be 12.68% [(1 + 0.01)^12 – 1 = 12.68%] a year, higher than the 12% APR. That is, if you were to only carry a balance on your credit card for only one month, you will be charged an annualized rate of 12%. However, if you carry that balance for the year (across a 12-month period), your effective interest rate becomes 12.68% as a result of monthly compounding.

I hope this piece was insightful. Share it with a friend who's thinking about opening a new credit card - make sure we are all informed!