How is My Credit Score Used?
The modern financial credit system has become so complex and advanced that it needed to find a simple measurement for the risk associated with lending to a particular consumer. Fair and Isaacs created the “FICO Credit Score” as a simple, objective risk management tool that helps a banker quickly analyze the likelihood of a consumer repaying a loan. The credit score reduces volumes of financial information to a single number rating that can be easily used for comparison needs.
The primary goal of a lending institution is to maximize its profit; a secondary goal is to reduce default rates. A credit score helps bankers accomplish both goals by providing a clearer view of the risk associated with providing a customer with financial services. Bankers can establish the best conditions for repayment of the loan.
A Loan is a Good Faith Promise
A credit score is a record of a debtor’s repayment history: how timely payments were made, how much credit is available, how much credit is being used, credit type, and any public records concerning the consumer’s debt. A credit score is a “faster,” “more objective” way to classify a debtor in terms of the “risk” of non-payment. Credit is still based on the “good faith promise” to repay the debt.
“How do Credit Card Companies Make Their Profits?
Credit card companies make the most money in the following ways:
- Interest on revolving debt
- Fees (Annual and penalty)
Customers who pay high interest rates on revolving credit balances account for the majority of a credit card company’s profits. Financial institutions use credit scores to decide who should get loans and the terms and conditions (interest rates, repayment schedule) for those loans. For a secured loan, the credit score can be used to determine the down payment; a large down payment (to pay recovery costs) will be required for those with bad credit who are more likely to default.
Most losses for credit card companies occur due to nonpayment. Since credit card debt is “unsecured,” a bankruptcy makes it very difficult for credit card companies to recover their money. Financial institutions will threaten to damage the credit scores of customers who don’t repay their loans.
Can I Still Get a Loan with a Low Credit Score?
Just as some companies cater to bargain shoppers while other companies cater to the wealthy, financial companies specialize in providing different types of loans to different types of customers. Some financial institutions used credit scores to “avoid” risky customers. Others use credit scores to charge “risky” customers high interest rates. Both use credit scores to “manage risk.”
Unlike, the old traditional banking model, which emphasized only “sound” customers who were likely to repay their loans, the modern lending model attempts to make money from consumers with good, average, and bad credit by charging different interest rates.
High Risk Leads to High Reward
The ultimate goal is to establish a “set of loan conditions” that will offset any potential losses from those who will default. Usually, this plan takes two primary appearances: 1) “High interest rates” or 2) “Numerous fees” to recover as much money as possible before the debtor becomes incapable of continuing to make payments. These banks charge “High Rates and Fees” to “High Risk” customers in order to generate a “High Reward.” Some large banks use small non-bank lenders to provide “payday loans” to people with poor credit at astronomically high interest rates.
Advanced Uses of Credit Scores
The credit score is used by many companies (financing, insurance, and housing) to measure character:
- Insurance companies try to determine if a customer is likely to make a claim
- Rental companies see if customers make timely payments
- Employers look for bankruptcies
Nowadays, many credit card loans and mortgages are repackaged into financial instruments, called “derivatives.” Using credit scores, financial institutions can lump together loans made to customers with “high credit scores” or diversify a portfolio with a mixture of loans made to customers with “high, medium and low credit scores.” The credit score helps potential investors value “derivatives.”