Sunday, January 22, 2006

Bad debt leads to good credit?

I have just finished buying my first car (used 2003, very low miles). In doing so, I followed my car salesman friend's advice and went to a credit union to get pre-approved for a loan. The conversation went something like this:

Me: I'd like to get a car loan for up to $20,000.
CU: OK, fill out this paperwork.

CU: My, you have the lowest debt-income ratio I've seen in a long time - 4%.*
Me: Yeah, I try to avoid taking on debt, I've had to recently because my job was only paying equity.
CU: That's a good reason.
CU: Ok, you've got a decent FICO score (650 from them, up to 750 other places - good to excellent if you don't know much about FICO scores), and you're asking for a loan that is less than what you can afford.
CU: Hmm... Do you have credit history.
Me: Yes, I've been building credit history for 5 years. My credit card limits have been increased steadily from $500 to $20,000 because I always pay on time.
CU: That's interesting, because it came back "denied due to lack of credit history"
Me: $20,000 in available credit is "lack of credit history" are you sure they aren't concerned with the amount of my un-secured credit lines?
CU: No, that's not a problem. Have you ever bought anything on installments? Do you have any installment payment history?
Me: No.
CU: That's the problem. There are two kinds of credit: Revolving and installment; you only have installment history. Thanks for comming in, perhaps you'll have better luck elsewhere or at a dealership.
Me: Thank you, goodbye.

* Debt/Income is calculated as: All Monthly Obligations (minimums on cc's)/Monthly Pre-Tax Income.

As I walked out of the credit union I kept pondering the fact that I could buy a car with the space on my credit card, but I couldn't get a secured loan for the same amount.

The upshot: Having, using and paying a credit card responsibly is not enough to build a good credit history! As you are building credit (i.e. as you are starting college), you should buy something on installments. Your computer, a digital camera, a mini-fridge, whatever. Something small that you can make monthly payments on easily to also build installment payment credit history.

The ideal situation would be that you could buy it cash, put that money into a high-yield savings account, and set up auto-payments each month. In effect you will have paid a little bit more for your camera, but far less than the high-risk premium you would otherwise end up paying to get a car loan once you graduate.

In the end, I got my financing through a dealership at 6% (a deal when you consider that t-bills are at 4.5% - that's the risk free rate; and when you consider that inflation is running at about 3%; thus the effective real interest rate on my car loan is only 3% and they think I warrent only a very low 1.5% risk premium). This is only .25% more than the best rate the Credit Union could have gotten me.

1 comment:

Clifford said...

Hey, I do a weekly write-up about credit scores/history on my blog. I'd like to reference this article in my next posting, if that's alright. You summed up what I was painfull trying to write last week.

Let me know!