Money 101: What is Credit?

Every day, institutions use credit as the basis for their decisions about consumers for a wide range of reasons.

Yet, sadly, many people don't learn how important credit truly is until they've made mistakes.

"Never depend on a single income."

~ Warren Buffett

The average FICO® Score in the U.S. as of August 2021 is 716

Fico.com

Most consumers know that a credit score is used by banks to determine if they will lend money to someone applying for a loan.

What many people don't realize, however, is that a credit score is used for so much more than just lending.

Banks will check a person's credit before opening a new account.

Cell phone companies will check credit before starting a new contract.

Insurance companies use credit scores as a factor to determine an individual's level of risk.

Employers check an applicant's credit as a way to determine their level of responsibility.

Yet, as important as credit is for the average consumer, many people don't understand exactly how it works.

What is a Credit Report?

The consumer credit system is made up of 3 distinct players: The Credit Reporting Agencies; the Creditors and the Consumer.

A credit report is a record of a consumer's history with debt obligations. The information is provided to the 3 major reporting agencies by creditors on a monthly basis: Experian, Equifax and Transunion. Most creditors report to at least one of the 3 agencies, if not all three.

Credit bureaus are for-profit companies that maintain expansive databases with billions of points of financial data on each consumer that creditors can use to analyze how risky a consumer might be. The three major companies tend not to share information between each other, so most customers will discover that the information contained in each of their reports will differ.

A credit file includes information on payment history, the types of accounts, the age of accounts, the balance on accounts and other personal financial facts. All of these different factors are run through an algorithm to determine a consumer's credit score.

What is a Credit Score

A credit score is a numerical representation of how likely a borrower is to repay a debt. It is created by analyzing the information in a person's credit profile and is expressed as a 3-digit number ranging from 300-850.

Potential lenders will evaluate a loan applicant's score to determine what their interest rate will be, IF they get approved for a loan at all.

People with good credit can receive favorable interest rates when buying a vehicle or a home. They also qualify for lower interest rates on unsecured debts such as personal loans and credit cards. Credit scores can even affect a person's insurance rates.

On the other side of the coin, bad credit results in a consumer being charged higher interest rates and ultimately paying hundreds, if not thousands, of dollars more to borrow the same money.