9 Debt

Creditworthiness can give entrepreneurs access to valuable resources and, for many (entrepreneur or no), is a basic necessity.  The credit report, generated by credit rating agencies, assigns a rating to individuals based on their history of taking on a fulfilling debt obligations.  While life “without loans” may seem ideal, credit reports are used for far more than applications for new loans.

Before moving through this section, try to brainstorm a few reasons why entities might base a decision on a credit report—why are credit reports used?

To understand credit and creditworthiness, forms of debt should first be considered. Most debt can be categorized as either good or bad: good debt benefits the borrower for a long time.  Usually obligations such as college loans and affordable mortgages are considered good debt.  Bad debt must be fed, is consumed, or loses value over time; this can mean debt for vacations, car loans, groceries, and other expenditures that lose their value or do not offer long-term benefits.  Of course, a car loan that enables the borrower to accept employment further from home that pays a much higher wage can be a form of good debt; and, a mortgage that is unreasonably high can be a form of bad debt.  When possible, annual bad debt should be limited to no more than 10-15% of annual income.

“Debt” is the obligation, but credit describes the ability of an entity to obtain goods or services before payment, based on the trust that payment will be made in the future.  Credit, then, is a measure of trust between lenders and borrowers, which may be established through a history of timely fulfillment of debt obligations.

Credit rating agencies assign credit ratings to entities as a result of data analysis against ever-evolving metrics, including: payment history, amounts owed on existing and past accounts, length of credit history, credit mix, and new credit.  Credit ratings describe the likelihood of an entity successfully and regularly paying back debt obligations over time; riskier loans might warrant higher interest rates or higher deposits up front to cover the potential for missed payments over the course of an obligation.

Consistent, timely payments are weighted most importantly in the rating; accounts with a history of delinquent payments are assigned lower scores.  Amounts owed on past accounts should be low relative to credit limits: a revolving credit card account with a limit of $2,000/month and a history of $1,900/month credit card bills is more risky to lenders than an account with a $2,000/month limit and a history of $250/month bills.  Account holders that are already using all of their available credit are less likely to be able to take on additional obligations, so the credit score is reduced until account holders are maintaining lower balances relative to their maximal spending ability.  New account holders are more risky to lenders than account holders with a well-established history of making complete, timely payments.  The process of establishing a healthy credit history is known as building credit.

Lenders or parties interested in determining one’s creditworthiness can request a credit report in the form of a credit inquiry, and these inquiries can be made with either more or less detail; a hard credit inquiry requests detailed information as part of an application for a new loan, line of credit, or as part of taking on a serious new debt obligation.  Hard credit inquiries usually indicate that the entity or person in question is actively seeking new debt, which signals to other creditors that you may have acquired new obligations that outpace the ability to make payments.  Because of this, recent hard credit inquiries lower the credit score.

A soft credit inquiry does not impact the credit score; but, the results of a soft inquiry may impact across person and professional life.  Although far from an exhaustive list, some common uses for credit inquiries are: starting with a new employer; applying for a lease, mortgage pre-approval, or loan pre-approval; starting a new account with a utilities provider.

Because credit inquiries can impact basic necessities of even personal life, building credit can have a positive impact on quality of life.  Good credit can enable access to financial instruments (like small business loans) that can potentially help a business through the start-up phase and beyond.