A Primer on Credit Scores (or why they invented credit score)

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A Primer on Credit Scores (or why they invented credit score)
2 years ago
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There was a time when all transactions were made purely on cash basis. You needed cash to buy anything and if you had lots of cash, you can expect special attention wherever you go. Since the invention of the modern credit card, however, the use of cash is viewed with suspicion, of wanting to avoid a money trail in an effort to hide something. Nonetheless, using credit cards is highly recommended for convenience and security, even more so if you have an excellent credit rating.

Your credit rating or credit score is an important issue in any credit dealing. Your credit report is a basic requirement in the processing of your application for a loan, credit card, car purchase, insurance, etc. It is a major factor whether you get an approval or not. A credit score is a measure of a person's credit risk. It is denoted by a 3-digit number that lenders use as a benchmark in approving a credit request, as well as in stipulating the specific terms of the loan. A person with a high credit score is considered to be creditworthy and a good risk for the lender. Higher scores may also get better deals for you.

Computation of the credit score is based on credit history as detailed in the credit report. Your credit report contains all your past and present credit dealings. It normally includes the debts you contracted whether outstanding or already paid, any mortgages you have taken out, credit cards accounts, store cards and other factors that may affect your ability to pay like your current employment and work history. The following factors are not considered in computation of credit score: the accounts of your assets like your money in the bank and the properties you own, monthly household expenses. The information contained in the credit report is gathered and organized by a credit reporting agency or credit bureau. The report simply supplies the data and does not any suggestion or assessment on the credit risk of the subject. It's up to the creditor to evaluate the findings and draw the conclusions relative to their need for the information.

Lending institutions like banks buy the credit reports generated by the credit bureau. They use the credit report to determine the credit score (using own credit score model) of their prospective borrower. A person's credit score may vary by up to 50 points depending on the loan purpose and credit score model used. This is due to the different risk scoring systems employed for each type of credit. There is one system for home mortgage, another for consumer credit and still a separate one for car loans. Though the credit score may vary, it remains indicative of the person's capability and willingness to repay the upcoming loan.

Although the various users review the credit report based on their own criteria, the credit scoring system basically involves the assignment of points to specific information about the person's financial dealings. The results are then compared against the composite profile of others in the same situation. The final output from the exercise is a quantitative value of the risk the lender will assume if they lend to the person whose credit is under review. This would explain why some people could easily buy high-priced items on credit while others face much difficulty charging their purchase of even small gadgets. That is how a high credit score makes the difference.

There are a number of credit scoring systems out there but most lenders use the model developed by the Fair Isaac and Company known as FICO system. This credit score model uses the credit reports from any of the three credit bureaus: TransUnion, Equifax and Experian although they also promote their own risk score models. Nevertheless, the basic principle behind credit scoring works the same in all the systems used. Banks and other lending companies have also formulated their own credit scoring system for their exclusive use.

The primary purpose of the credit score is to gauge the creditability of an individual. It also serves as a predictive tool for possible default by a loan applicant. Your credit score is a number that represents how likely you become delinquent in the next 90 days. Then again, numbers are only numbers.

The downside to the credit score is its failure to include subjective factors like the prevailing economic and political conditions, as well as other unforeseen events that gravely affected the person's financial situation and hence, resulted in a low credit score. The quantitative analysis needs to be coupled with a qualitative study to fully establish one's credit worth.
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