PROPERTY BAROMETER – being a responsible spender...

How can I avoid a poor credit score?

28 November 2012

Dear Reader.

It’s hard to believe that the festive season is once again upon us.  Considering the current economic climate, coupled with the expected increase in household expenditure over the festive season, It may be best to heed caution in the coming months. I am hoping you will find value in my thoughts on festive season spending and the risks of not managing one’s spending going into the New Year.

In order to best understand what possible pitfalls exist on the lending side, it requires a better understanding of the credit scoring environment and how to avoid being caught unaware when applying for credit.

                                           
Consumer health….

Consumers are unfortunately not all in great financial shape, and it may take some time before we see á strong household sector financial position. The Reserve Bank shows the household debt to disposable income ratio rising again, encouraged by interest rates at a 40 year low, and utility bills are on the up. Household disposable income growth is coming under pressure in a weak economy, potentially running the risk of overexposure on short term debt whilst net savings rates (gross saving minus provision for depreciation on fixed assets) remain at zero. While a bank has a duty to try to lend responsibly, ultimately it is the consumers’ responsibility to make the right decisions and manage their finances appropriately. Hopefully this article will help give some insight into what can be done to improve the chances of getting that elusive loan.

 The National Credit Act….
One of the fundamental shifts in how credit agreements are assessed, since July 2007 with the introduction of the National Credit Act, requires a credit provider to consider all existing credit agreements already in place with a loan applicant. When a client applies for credit, the lender must be able to prove that it was prudent in its decision making, and has taken all existing debt into consideration before granting the additional credit. The credit provider must show that it did not place the client in a position where he could not service all their debt at the time of granting the loan. In the past, exposure at other lending institutions was not all taken into account, potentially resulting in a “rob Peter to pay Paul” scenario. 

It’s not only all existing debt that needs to be taken into account Living expenses are also a factor. Income and expenditure forms have been around for a long time, but unfortunately the importance of this document is understated. The impact of a client declaring incorrect expenditure places him at risk, as the document is a legal and binding declaration. The risk of reneging on an agreement after completing an income and expenditure form showing sufficient surplus income, could result in your credibility as a client coming into question should the credit provider need to quantify its decision in court.

Taking into account the amount of work required to investigate a client’s current exposure, how they service these commitments and the monthly installments required, credit bureaus play a vital role in assisting credit providers with the insight needed to grant or decline an application. The checks and balances required when assessing an application have increased substantially, and relying on an individual to sift through all of the information would result in credit applications taking far longer than they currently do.

What Credit Bureaus reflect…

It is for these reasons that scoring models and automated score cards are used to sift through the volumes of applications. One of the common unfortunate casualties of adopting a scoring model is the risk of a client not having any credit history at all. Hence the adage “you need credit to get credit.” That being said, insurance companies, cell phone companies and even Telkom accounts help in creating a credit score, as the companies update the bureaus with the payment behavior and how well the accounts are serviced. How else would a credit provider ascertain the ability to service debt responsibly and take comfort in the idea that their debt will be paid on time? The converse applies as well, having numerous  limits available, even if  paid up, doesn’t necessarily reflect as a positive., the risk of lending to a client that has too much credit available, even if it’s not being utilized, could result in the client being overexposed if they exercise their  right to access these limits.

As with anything, all good things must be done in moderation, and consumers are required to act more responsibly when taking on any form of debt. Gone are the days when it was acceptable to pay accounts in alternating months. Even paying late reflects negatively. The onus is on the consumer to be responsible and pay the full amount required, and on time. Due to the complexities within scoring models and the permutations that exist, it’s not as simple as paying all your debt on time that will get you a good credit score. To illustrate the point I have simplified an example below.

Clients A and B apply for the same loan amount, they earn the same income, they have the same qualifications and have the same retail limits. Client A pays his accounts religiously and never misses a payment date, Client B pays every  month as well but doesn’t always pay the full amount, client B pays some on time and the balance a week or two later,  bringing his payment profile up to date within the same month. Chances are strong Client A will get a better deal from the bank and possibly more credit than client B, because he services his debt in line with what was agreed to. When entering into debt that requires a monthly minimum to be paid by a certain date, it is vitally important to pay the minimum or more and never less, and on time. If the payments are erratic and not paid on time, it immediately raises the question of being able to service more debt, if you cannot manage what you already have.

Understanding and Managing the outcome….

 Given the stringent lending requirements when granting long term credit, as in the case of a home loan , the need to make sure that all debt is considered, and that the bank is aware of all exposure, would take a lifetime for an individual to investigate. It is for this reason that credit scoring systems have become such an integral part of lending sector. 

Credit scoring models serve two primary purposes.

a)       They help calculate a client’s propensity to default. In other words, they help calculate the likely hood of a client not paying the loan back on time and or defaulting on the agreement.

b)       They aid in gaining insight into the client’s payment behavior and current exposure.

Considering the upcoming festive season and the temptation to use those credit cards and retail accounts, we must consider the impact of our actions if we are going to apply for credit in the New Year. If buying a home is on the cards, racking up short term credit over Christmas may well stand in your way. Below are some pointers on what to do, irrespective of the time of the year, but, more so now given the hype and temptations.

·         It is important to keep the amount of debt or short term commitments to a minimum. Clothing accounts, personal loans, overdrafts, credit cards and vehicle finance can erode the amount you could qualify for and it would be best to manage these down. Having a facility available but not closing it still means the credit is available and would need to be considered when applying for more. It is best to cancel or close unnecessary accounts if not being used.

·         Do not merely accept the annual limit increases on store accounts or credit cards due to being a “good client”, they can detract from the amount you qualify for.

·          Pay your monthly accounts on the due dates; do not skip payments from month to month. If an account is due on the 25th of the month, do not pay the account late as this will affect your credit rating. Pay on time. If the minimum amount required is R500, pay the R500 and not less as this will reflect as a part payment and detract from your overall consumer score.

·         Whilst it is important to shop around and make sure you’re getting the best deal upfront, be aware of the number of credit checks done on your profile. This indicates a need for credit and detracts from your overall credit score.

·         As far as possible avoid standing surety for others. This is considered when raising finance for your own purposes, and will affect the amount you qualify for.

·         Pay your salary into an account monthly to build up a credit score with your bank. Try not to use everything up all the time, and in so doing continuously be running your account on the minimum balance monthly. This too is an indication that cash flow is tight and extra expenses could be a problem.

·         Don’t overdraw your account. Constant overdrawing of your account shows insufficient cash flow which could raise the question about how you plan on servicing new debt if you can’t manage what is already there.

·         Having a savings account is always a good thing: it shows there is extra money available every month and indicates a prudent approach to managing your finance.

Whilst the temptation exists to extend the credit card and spend a little extra over the coming months, a cautious approach to overspending may help avoid a post holiday hangover that could end up being far worse than initially thought. Credit scoring and score cards have been around since the late 1800’s and continue to evolve. Understanding the impact of one’s behavior  on your own scoring may well help secure that dream home in the new year…..let’s not only be safe this December, but prudent as well…

Regards,