Credit scoring systems make many people nervous -- they're so "judgy." Especially today, when employers, insurers, landlords and others may use credit scores to draw conclusions about those with whom they do business, perhaps denying employment, insurance coverage or a place to live. However, credit reporting wasn't invented to trash people's self esteem or wreck their lives.
Not Psychic, Just Systematic
The purpose of credit scoring systems (like FICO, the most widely-used) is to predict the likelihood that borrowers will repay their loans as agreed. Credit bureaus (the three biggies are TransUnion, Equifax and Experian) know how scores correlate with actual lender experiences and can say how likely someone with a score of X is to default on a home loan, credit card or auto financing.
The bureaus continually double-check and tweak their algorithms, making sure they stay accurate as economic conditions, laws and other factors change the way consumers repay (or don't repay) their debts. That's why companies use credit reporting -- to set appropriate interest rates for customers with different credit ratings. This helps them maximize sales (grant credit to as many buyers as possible) while minimizing losses (avoiding too many defaults).
Borrowers In Tiers
Once lenders have this information, they put loan applicants into groups and assign interest rates to those groups. These rates should make the lender's profits about the same for each group of borrowers. For example, if one of every hundred borrowers with FICO scores of 760 or higher defaults on credit card debt, that means lenders can expect to lose about $1,000 for every $100,000 they lend to this group. If the lender needs to make a profit of five percent interest, then, it will have to charge these borrowers 6.1 percent interest. The extra 1.1 percent makes up for the expected losses by this group.
Here's a chart showing what lenders would have to charge to make the same profit from different groups with different FICO scores and default rates. Notice that these higher rates are not charged to "punish" those with lower credit scores; they are put in place to ensure that the lenders make their expected profit regardless of the borrower's credit score.
Applicants for mortgages, auto financing, personal loans and credit cards see this difference all the time. For example, auto financing rates for those with top-drawer credit start at less than three percent -- but run to nearly 20 percent for those with poor credit ratings -- and at some dealerships go to 30 percent or more. Credit card rates and personal loan interest rates start at about seven percent for prime borrowers but can exceed 30 percent for scruffy applicants. And mortgages? 30-year fixed loans for those with FICO scores of 760 or better are at 3.950 today, but they're at 4.326 for those with 620 scores. For those with lower scores, rates can be much higher -- into double digits in fact.
It takes time to change a bad credit score into a good one -- paying down balances and paying on time. Debt consolidation can also help, but only if the debt consolidation loan is paid on time, and only if the original accounts are not run back up. Debt consolidation doesn't really pay off anything -- it just replaces several accounts with one, hopefully at a lower interest rate.
Those who wish to raise their credit scores can start by getting their free Vantage Score at LendingTree. They can track their improvements over time for free and even get offers of better credit at lower rates as their score increases.