Understanding Credit Terms Crucial for Financial Smarts

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Bills.com provides a list of basic definitions every money-smart consumer must know

With the most common credit score formula getting an overhaul this month, the free online consumer portal Bills.com (http://www.bills.com) has compiled a list of the basic credit terms every American should know.

"Managing money isn't always easy, but it can be simpler," said Andrew Housser, co-founder and co-CEO of Bills.com. "By knowing the meanings of these basic terms, especially in light of the pending release of FICO 08, Americans will be better positioned to take charge of their credit score."

The three major credit reporting agencies - Equifax, Experian and TransUnion - report consumer credit scores based on the Fair Isaac Corporation's FICO formula. This spring, Fair Isaac will unveil FICO 08, intended to help lenders better gauge actual risk by better differentiating good customers who have made one mistake from people with multiple delinquent accounts.

Housser's must-know terms include:

  • Average Daily Balance or Adjusted Balance: Methods of calculating a credit balance and interest on a debt. Average Daily Balance is the practice of crediting an account from the day a payment is received or debiting an account on the day a charge is made. The lender adds the beginning balance for each day in the billingBottom of Form period to the charges made that day, and then subtracts any payments and/or credits made to the account that day. Adjusted Balance adds charges and subtracts payments made during the billing cycle from the balance at the end of the previous billing cycle. This method is more advantageous to borrowers and credit card holders. Unlike Average Daily Balance calculations, new purchases during the billing cycle are not included in Adjusted Balance calculations, and interest is only applied to the balance remaining after payments are credited to the account.
  • Amortization: The gradual reduction of debt through regular payments of principal and interest.
  • Annual Percentage Rate (APR): The yearly rate lenders charge borrowers to borrow money (also called the cost of credit). Lenders must divulge the APR they are charging prior to finalizing the deal. Some credit card and loan companies state in their agreements that they can change the APR when interest rates or indexes change.
  • Bankruptcy: A form of financial protection a debtor seeks when he or she becomes unable to pay mortgage payments or other debts, has no credit or means of paying, and/or is unable to reconcile with collection agencies. Two methods exist to file for personal bankruptcy: Chapter 7 and Chapter 13. A Chapter 7 bankruptcy eliminates most types of debt (notable exceptions include taxes, alimony, and most student loan debt) by liquidating all non-exempt property (as set forth in the Chapter 7 filing) to pay debts, and wiping out anything left over after the liquidation. A Chapter 13 bankruptcy allows a borrower with a steady income to establish a full or partial debt repayment plan, usually over a 36- to 60-month period.
  • Credit score: A number between 300 and 850 that measures an individual's creditworthiness based on credit history. Scores are calculated using mathematical methods that incorporate credit history, amount of credit used and available, number of late and on-time payments, whether any payments due are in default, and other variables. Also called a "credit rating," which can be broadly categorized simply as "poor," "fair," "good," or "excellent."
  • Liquidation: The process of converting assets into cash to pay off creditors. This process is used in personal and corporate bankruptcy as a solution to getting out of debt with lenders.
  • Repossession: The forced or voluntary surrender of property as a result of failure to pay debts associated with that property. If a buyer incurs secured debt in the purchase or refinance of real or personal property, and fails to make timely payments on that debt, the entity that holds the debt may reclaim the property through repossession.
  • Revolving account: An account that does not have a fixed amortization schedule and is not required to be paid to zero every month. Credit cards are generally considered revolving accounts. These accounts require a minimum payment each month, which includes the monthly interest plus a portion of the principal. Borrowers can choose to charge more to add to the debt (up to the credit limit), or pay it down as much as they choose each month.

"The financial world is complex, but by beginning with the basics, you will build your understanding of credit and be ready for whatever your credit history throws your way," Housser said.

Based in San Mateo, Calif., Bills.com is a free one-stop online portal where consumers can educate themselves about complex personal finance issues and comparison shop for products and services including credit cards, debt relief assistance, insurance, mortgages and other loans. The company blogs about consumer finance issues at http://www.bills.com/blog. Since 2002, Bills.com has served more than 30,000 customers nationwide while managing more than $500 million in consumer debt. Bills.com is a division of Freedom Financial Network, LLC, whose co-founders and CEOs, Andrew Housser and Brad Stroh, have been named Northern California finalists in Ernst & Young's Entrepreneur of the Year Awards.

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Aimee Bennett
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