The cost of credit is dependent on many factors. Personal financial responsibility combined with Federal Reserve Board's decisions and actions work to determine how much the privilege of credit will cost. Knowing and understanding how these factors work together can help you make smart decisions and lower your credit costs by affording you the lowest interest rate possible.
Personal Factors
The role personal financial responsibility plays in determining how much credit will cost is an important one. Credit granters determine your credit worthiness and assign a risk factor that reflects past financial performance. Factors such as whether you pay bills on time, how many credit accounts you have, the type of account (credit cards, mortgage, auto loan) and how much you owe on the accounts vs. your income all combine to assign a risk level. Your risk level then translates into a number between 300 and 850. This is your credit score. According to Experian, a leading credit score provider, the average score is 693.
Prior credit history is one of the most significant factors affecting your personal credit rating. The better your payment history, the higher your credit score.
The type of credit in your file will also help to determine how much credit will cost. Lenders view secured debt, such as with an auto or home loan, more favorably than unsecured debt, such as with credit cards. A credit file containing large amounts of unsecured debt looks considerably more risky. It will usually command a higher interest rate than a credit file containing mixed types of credit.
Income vs. the amount of debt you possess is your income-to-debt ratio. This percentage includes available credit, such as the limits on credit cards, as well as actual debt you incur. For example, if you have four credit cards with a zero balance on each but a credit limit of $4,000 on each, your debt-to-income ratio will take into account the $16,000 of credit available to you. Depending on your income level, this could affect your credit rating.
Market Factors
The U.S. Federal Reserve is responsible for creating stability, flexibility and safety in the U.S. monetary system.
Two divisions of the Federal Reserve work together to establish our monetary policy and influence supply and demand. The Board of Governors sets the discount, or interest rate, charged to banks to borrow money from the Federal Reserve, and the reserve requirement, or the amount of money banks must keep in liquid form. The Federal Open Market Committee is responsible for open market operations, or the purchase and sale of U.S. Treasury and federal agency securities. Together, these branches influence supply and demand and affect the federal funds rate. This rate directly affects the amount of money in circulation at any given time and the resulting cost of credit. The less money in circulation, higher the interest to the bank, and the higher the interest rate is to the consumer. The same is true in reverse with a plentiful money supply.
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