Personal Finance & Money Asked on December 31, 2020
This might be a silly question, but I’m trying to wrap my head around how the US Credit Score works. I’m from Europe.
Credit Score represents creditworthiness, which as I understand it, represents a balance between potential gain and risk for the banks. Credit Score, where I’m from, tends to lean toward the risk aspect. If you have a bad history of repaying your loans, then you are a bad client and you most likely won’t get any more loans from banks. However, in the US, it seems to me that this score tends to lean toward profitability for the banks and less so towards risk; you still get access to credit but at a higher interest rate (which feels strange to me; maybe because I’m from a different culture).
For example, paying the minimum amount on your credit card seems to be OK and doesn’t negatively affect your credit score, although paying the minimum amount is a high risk factor because it shows you don’t have the money to pay back the full amount. There is a risk that you will default on your loans, but it’s also profitable because you end up paying more interest in the long run. Risk vs report doesn’t seem to be in balance and leans towards profit.
Another thing I don’t understand, is that job stability or income stability doesn’t weigh much in calculating someone’s credit score.
So what exactly is the purpose of the credit score in the US? Does credit score show you are a responsible borrower or just a profitable client for the bank (even though riskier)?
On that idea, one other question. Credit score is also used in other aspects of life, like renting a home. Does a landlord looking at someone’s credit score to decide on accepting someone as a tenant, thinks that a good credit score is an indicator that the person is financially responsible and there are less chances to fail paying their rent, or is it that, if they do fail to pay the rent, then they have better access to credit to be able to pay the rent? Or is it just some misconceived belief that good credit score equals good tenant? How exactly do other entities (besides banks) use the credit score?
So what exactly is the purpose of the Credit Score and how does it get used in more aspects of life than accessing credit?
The point of the credit score system for banks is to attempt to make every customer equally profitable.
According to the rating agencies, a customer with a bad credit rating is statistically more likely to stop paying installments on their debt (which means a lot of hassle for the bank) or even declare personal bankruptcy. That means the bank loses money on this customer. If low-score customers would pay the same interest rate, then the bank would make less profit from this strata of customers. So they raise the interest rate until the expected payout from low-score customers is the same as that from high-score customers.
The reason why landlords (and most other people who engages in a contract which involves someone paying them money in regular intervals) care about credit scores, is because a tenant who is unlikely to pay loan installments on time is equally unlikely to pay rent on time. Sure, a bankrupt tenant can be evicted and replaced by someone else who hopefully got their personal finances in better order. Banks don't have that option with a non-paying debtor. But evicting and replacing a tenant takes time and effort. So it has an opportunity cost for the landlord which they have to pay themselves.
Answered by Philipp on December 31, 2020
Your credit score is a critical part of your life. Your credit score basically helps to determine the probability that you could and would pay back the money that you have borrowed, it also indicates the degree of risk that you pose to a lender.
Increased credit risk means that a risk premium must be added to the price at which you borrow money. If you have a poor credit rating, lenders may not shun you; but instead, they'll lend you money at a higher rate than that paid by someone with a better credit rating.
Answered by Irfan Shaikh on December 31, 2020
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