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 and 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 charged 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 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 of never getting the money they lent to you back. 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 even 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 (two papers of three pages each, 10 journal entries, a midterm, a final research paper of seven 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 five pages when the minimum was seven pages. The credit score is similar. Lenders lend money that must be paid back over time at specified periods on certain dates. Borrowers who pay late, pay partial amounts, don’t pay, and/or have much more debt than they can likely afford have lower grades, or credit scores. If borrowers don’t do the “assignment” on time and have a record of not doing so in the past, the lender sees them as a higher risk for paying back future loans and charges more to lend to them or won’t lend to them at all. The credit score can seem unfair, but it’s the tool that is used today to measure who is an A student in the credit world and who is not going to pass the class. That’s the reasoning behind the credit score and its importance. (For related reading, see: The Importance of Your Credit Rating.)
How Good Credit Saves You Money and Affects Your Job
If you have good credit, borrowing costs you less. Home mortgages, auto loans, personal loans, low-interest-rate credit cards and the ability to get credit cards with temporary 0% balances are available to you in a way they won’t be if you don’t have good credit. When your credit score is low, getting any loan is tougher and more expensive…or impossible. So not having good credit can cost you a home or car; it can make you pay more for using credit cards or prevent you from getting them; or it can drive up the interest rate of a personal loan. It can even keep you from getting a job you want because employers are allowed to check your credit and use it as a factor in hiring you. (For related reading, see: What Is a Good Credit Score?)
Action Items for Maintaining and Building Good Credit
It’s a hard reality that the cost of borrowing money can be very high for those with bad credit. If you have good credit now, working to keep it is very important. If your credit score is low, it’s worth the effort to improve it. In general, to have good credit you need to pay bills on time and reduce debt to a reasonable amount. Investopedia has a number of great articles with specific tips on how to improve your low credit score or keep your good one. It’s worth the effort to do so because it will save you money in the future.
(For more from this author, see: Financial Tips for Parents on a Tight Budget.)