Where Credit Information Comes From
Where does your credit come from? Are you born with it? No — if you don't use credit, you don't have credit; your credit is a result of your behavior in the world. Some of the most important information comes from your dealings with creditors. Of course, it is your credit, so the most relevant information comes from your use of credit.
Information Sources
The information that makes up your credit comes from numerous sources. Other sections of this book describe the sources in greater detail. For now, suffice it to say that there are a lot of organizations talking about you:
Lenders
Prospective lenders that you never worked with
Government and court systems
Collection agencies
Credit-reporting companies
Depending on how you define your credit, information can come from a number of additional sources. Insurance companies report information on their customers to specialized databases. Landlords who rent properties share and use information about tenants. Finally, banks and retailers may share information about your check-writing habits.
Credit Scores
When you think about credit, you may think of the concept of a credit score. What exactly is a credit score? The credit score is a number that attempts to rank you on some level of creditworthiness. The credit score might tell potential lenders how likely you are to make late payments.
Your credit score does not determine whether or not you get a loan. The credit score is simply a number that ranks you with the rest of the population. Your lender may have a policy on granting loans based on credit scores, but the scoring programs do not know that. They just generate a score.
Imagine how difficult it must be to predict whether or not a customer is likely to pay late. Imagine yourself as a loan officer in a bank sitting across the desk from a potential borrower. What criteria do you use to judge this person's creditworthiness? You may pull credit reports from the major credit-reporting companies — if you have ever seen these reports, you know that they are full of information and can be several pages long. Then, you might read through their reports to get an understanding of how your potential borrower has behaved in the past. Finally, assume that you have three more potential borrowers waiting to see you, and you have not had lunch yet.
This scenario helps to highlight why credit scores may be useful. People have to make lending decisions with several goals in mind. They may want to grant the loan so that their organization earns interest income. They may also be motivated to grant loans in an effort to help serve the community, for example, making mortgage loans available to low-income households. On the other hand, the person making the lending decision has to try to minimize losses. The organization won't be able to help anybody if it loses all of its money.
Automate It
To make lending decisions easier, lenders often use credit scores. A computer program does a lot of the work, leaving just a few items for the person responsible for making a decision to fill in. In some cases, the computer program does all of the work, and human eyes never see the potential borrower's credit information. The credit-scoring model looks for good things and bad things in the borrower's history. It looks for late payments, bankruptcies, and maxed-out credit cards, among other things. These are the same items that a human would look for. Of course, the computer can do it in a split-second.
A 2005 study released by the Consumer Federation of America and Providian put a number on how much you can save with a better credit score. For consumers with an average credit score, a thirty-point increase would result in $76 of annual savings on finance charges. Of course, more significant positive changes in your score would yield more significant savings.
In addition to speeding up the process, credit scoring can level the playing field. Lenders might have biases that influence their decisions when considering an applicant's creditworthiness. From a fairness standpoint, creditworthiness should be the only factor considered. However, people responsible for making lending decisions might be swayed in one direction or the other for irrelevant reasons: if the applicant is good or bad looking; if the applicant has a health issue with negative stigma attached; or if the applicant seems friendly or unfriendly. In some cases, lenders may discriminate because of an applicant's sex, race, or creed. Credit-scoring models can eliminate these biases from the equation, because they look strictly at the credit history data. If the applicant has a good credit history, the score is high regardless of any personal traits.
Who to Lend To
Credit scoring makes it possible to make a large number of small loans. Lenders get flooded with applications for credit. How do they determine which ones to process? If they are strapped for resources (time and person-nel), they might decide to limit themselves to the loans that are more profitable. In this case, they might focus on the larger loans only because smaller loans require the same amount of processing but pay less interest. Credit scoring makes it efficient to look at loans of all sizes, which makes it easier for consumers to get loans.
Where Scores Come From
Where exactly do these credit scores come from? There are a variety of companies that create credit scores. These companies are described in greater detail later in this book. For now, you should understand that the credit score may or may not come from your lender. In many cases, it does not. External companies create the computer programs used to generate scores.
The computer programs are just empty programs that take in information and process it. They're designed to work with different systems. For example, the FICO credit score is designed to work with the data held at the major credit-reporting companies (TransUnion, Equifax, and Experian). The credit-reporting companies load the software, and then load the credit history for the individual who they are going to score. The software spits out a score, and it is forwarded to whoever asked for the report.
Mass Confusion
The world is full of confusion about credit scores. In part, this is because credit scores were unavailable to consumers for many years. In addition, the entire world of credit and credit histories can be intimidating. Unfortunately, ignorance is not bliss when it comes to your credit. The majority of consumers, 69 percent of them, have not checked their credit within the last year.
In 2005, a study released by the Consumer Federation of America, Providian, and myFICO.com explained the state of affairs. They found that about half of the American population does not understand the basic concept of a credit score. Indeed, only 51 percent of respondents in the study knew that a credit score represents credit risk. The other 49 percent thought a credit score described credit availability, credit IQ, or levels of debt. In addition, 45 percent of respondents thought that getting a substantial pay increase would result in a higher credit score. While it is possible that there might be an indirect link between your pay level in your credit score, many highly paid people borrow too much (the more you earn the more you spend) and can end up with a very low credit score.
