By Michael Feng. Edited by Arjun Chandrasekar.
Overview
All transactions are based on the assumption of one thing: trust. When buying something off Amazon, you’re trusting the seller to deliver the product you buy. If you don’t receive something satisfactory, Amazon has customer service that will support you. Without the trust in Amazon to get you the product you buy, you wouldn’t buy from Amazon. Similarly, banks and financial institutions require the trust that you will pay back loans that they lend to you. But how do banks measure how trustworthy you are? Using something called a credit score, banks are able to gauge how financially responsible you are and whether or not you are worthy of a service they provide.
According to consumerfinance.gov, “A credit score predicts how likely you are to pay back a loan on time. A scoring model uses information from your credit report to create a credit score.” Using a mathematical formula, or scoring model, companies gather a variety of information about your credit and finances to determine your credit score. According to usa.gov, factors include:
- Payment history
- Outstanding balances
- Length of credit history
- Applications for new credit accounts
- Types of credit accounts (mortgages, car loans, credit cards)
Now that you’ve learned about how credit scores are calculated, we’ll get into why you would even want a good credit score in the first place, and then the benefits of having a good credit score. First off, a good credit score gives you low interest rates on credit cards and loans. To explain why, we’ll refer back to our introduction about trust (this explanation will apply to almost all other benefits as well).
Trust & Risk
Recall that a higher credit score means that banks recognize that you’re more responsible with your money, pay off debts, and have been able to do these well for a long time. Because banks know that you’re more likely to pay them back if they lend you money, they take on less risk of losing the money they lend you, charging you less money for interest. On the other hand, if you have a bad credit score, banks know that you may not always pay back on your debt, don’t have a reliable income, or that you’re financially irresponsible. Due to these factors, you’ll be less likely to make a full payment on your loan. Therefore, banks will charge high interest in order to recoup as much of their loan as possible in the case that in the future you default or are unable to pay the rest of the debt.
To boil it down in one last explanation, the chances of someone having a good credit score and not paying back debt, hypothetically, might be 1 out of every 10,000 people. Therefore, for every 10,000 people, banks should charge each person a certain amount of interest so that they will cover for the one person who cannot pay back their loan, while still earning money.
However, for those with a lower credit score, hypothetically again, maybe 100 out of 10,000 will be unable to pay back their debt. Thus, banks need to charge a higher amount of interest to recoup the losses those 100 people incur when being unable to pay back their loan while still earning a profit. Now for those of you mathematically curious, you’ll think: “but these are averages, the people who can’t pay their debt will fluctuate over time.” To this, the law of large numbers is important to reference, since instead of 10,000 people, banks deal with millions, if not billions of customers.
Benefits
Now that we’ve explained why banks may give out benefits for those that they can trust more, or have a higher credit score, let’s get back to what those benefits are. Some benefits out of many are: a higher chance to get approved for credit cards and loans, more negotiating power on interest rates, and getting approved on higher spending limits.
Lastly, as a quick guide on how to maintain or increase your credit score, some good tips to follow are to: pay off your loans, don’t get near your credit limit, a long credit history, and to only apply for credit you need (don’t apply for a lot of loans or credit cards in a short period of time).
Conclusion
Ultimately, the difference between saving thousands on interest for your mortgage and paying absurdly high rates on loans may just be that one month of credit card payment you couldn’t pay in full, lowering your credit score. Hence, learning everything you can about credit scores is crucial before you make mistakes early on in life, and hopefully this article helped!
1 https://www.thebalance.com/having-good-credit-score-960528
2 https://www.consumerfinance.gov/ask-cfpb/how-do-i-get-and-keep-a-good-credit-score-en-318/
