You can’t chill on the couch in front of Game of Thrones or NFL football for more than 20 minutes without seeing a commercial about credit scores. The credit score is everywhere today, dominating almost every aspect of buying. Why does it matter?
The Definition of Credit
Credit and credit scores have become somewhat tyrannical in our society. Let’s talk about the general idea of borrowing and lending money and then talk more specifically about credit scores. To briefly define our terms, buying on “credit” means buying an item or service that you take home as your own while promising you’ll pay for it in the future. There is a fee for doing that, and it’s called “interest.” The interest rate is the amount that is charged by the lender as the cost to you for lending you the money. Interest rates vary based on the type and originator of the loan, in addition to many other factors. Businesses don’t work for free, and the service of lending money has to have a cost that is charged to the borrower that in turn makes money for the lender. The lender is in the business of lending money and needs the return of the money lent plus the revenue of the interest rate charge to be profitable.
Types of Credit – Secured and Unsecured Loans
A good place to start talking about lending is in the difference between a “secured loan” and an “unsecured loan” because it is an important distinction and a great differentiator in the interest rate offered. A “secured loan” means that you use an asset such as a car or house as collateral for the loan. Rates tend to be lower for secured loans because lenders figure they can sell the house or boat or car to get back their money if you don’t pay the loan back. In simple terms, that’s why a mortgage today can be at 3% or a car loan at 4% – the lender has that house or car to collect from you to offset the money owed.
An “unsecured loan” is guaranteed only by your promise to pay it back. If you don’t pay, lenders will certainly work to get their money back, but, as the saying goes “you can’t get blood out of a turnip.” So lenders run the risk never getting back the money they lent to you. That’s why they charge a higher interest rate on an unsecured loan. Unsecured “loans” include credit card debt. Credit card lenders charge between 12 and 22% or more because they have no recourse or collateral to pull from if the borrower doesn’t pay them back. On the consumer’s side, that seems unfair and unreasonably high, but to the lender, it’s the only financially safe way to protect their business profit from borrower default.
What the Credit Score Tells Lenders
When a consumer asks to borrow money, the lender needs to evaluate the likelihood of repayment. The credit score is a reflection of borrowers’ behavior in paying their debt. It’s kind of like a grade in a class at school. The teacher sets the due dates and the assignments (2 papers of 3 pages each, 10 journal entries, a midterm, a final research paper of 7 pages with sources), and the students get higher or lower grades based on how well they complete the assignments, whether they meet the length of the assignment or are too short, and if they turn the assignments in on time or late. Missing some or all of the requirements lowers the grade; you won’t get an “A” if you turn in 5 pages when the minimum was 7 pages. The credit score is similar. Lenders