To understand how credit works lets look at few prevailing systems and their significance in credit industry:
Ever wondered…” what credit reporting system is all about”.
This system informs banks about customers who have already extended their maximum credit potential and whether they have any history of non repayment.
In ancient days banking used to be a more personal and interactive. If someone required a loan, vising the branch and convincing the loan officer was the first step to start the process. This was further followed by analyzing the income of the customer and providing customer references (more like a guarantor) to prove the repayment capacity. In those days, loans used to be backed by collaterals and so we were more secured in nature.
However, when we look at banking system and credit management process today, its easy to witness how drastically the foundation of credit system has changed. Be it a personal loan, education loan or a credit card, most of them are unsecured today and still banks make sure to get back the amount and earn highest revenue possible. If at one side unsecured lending is more profitable for the bank, on the other its quite riskier as well.
With the introduction of credit reporting system, banks can easily track all the information about its potential borrowers. This centralized system facilitates banks to retrieve information about anyone who has a credit history.
You must already be familiar as to what credit worthiness is all about, broadly its a tendency of borrower to pay off all his debts on time which is essentially required for anyone to get the next credit or loan advances from banks easily. You are offered credit card, personal loan, education loan, auto loan or housing loan based on your credit worthiness. In order to substantiate worthiness of a customer, the concept of credit score was introduced, which is basically a numerical value to identify the level of your credit worthiness.
Role of credit bureaus to understand how credit works:
Credit bureaus also referred as credit reporting organizations are responsible for maintaining, collecting and informing details about customers with repayment histories. It gathers information like how many times a customer has made timely re-payments and number of times there were instance of defaults and partial re-repayment.
All these information are stored in a highly secured database and are assessed by banks and other financial organization for evaluating credit worthiness of potential borrowers. Usually, credit bureaus levy service charges on the banks and financial bodies for accessing these credit reports.
Credit bureaus are only responsible to provide information relevant to your credit history, however they are not responsible to decide if you hold a good or a bad credit rating or if the loan should be granted or not. The bank officials are ultimately responsible to decide the same after reviewing the credit reports shared by credit bureaus.
Names of few world-famous credit bureaus.
In United States, there are three famous credit bureaus which provide credit information of potential borrowers -Equifax®, Experian® and TransUnion®. Financial organizations also send credit information of borrowers to credit bureau regularly for reporting purposes and in-turn credit bureaus maintains the same in its database and use these to derive credit scores and design credit reports for future references. The contribution of all the above credit bureaus are vital to figure out how credit works.
What are the contents of credit report?
Basically a credit report contains all the details about the repayment history of a borrower. It also contains information like number of loan accounts, credit cards, utilization ratio, non-repayment count, blacklist category and all such details which are essential to determine the credit worthiness of consumers.
Credit reports are minutely assessed by lenders to determine the credit limit, interest rate, risk involved and ultimately to decide whether no not to provide approval for the requested loan amount.
It also contains information like full name, address, date of birth, employment information, SSN and borrowing related information such as loan accounts, due amount, and re-payment history.
Credit inquiries are also one of the important information that comes handy with a credit report. An inquiry is basically details of a borrower which reflects if at any time the loan application was rejected in past and the reason behind the same. A reject reason mentioned in the report may further call up additional reviews and supporting documents for processing the application further.
To be explicit a credit report contains information regarding all the following types of your account :
Closed accounts: All those account which are currently closed would also be reflected in report for references and the information of closed accounts may also be retrieved by financial organizations if at all required.
Revolving and Non Revolving credit accounts: A revolving account is one that gets re-instated after you repay the utilized amount and you would be able to withdraw the same amount again and again in future as long as you make repayments. However, a Non revolving credit account is one that does not get refreshed automatically after utilizing once, for example- personal loans.
Collection accounts: These accounts are those which you have linked for your utility payments. This account is also made available in your credit report for reference purpose. At any time, the bank wants to look at your collection accounts, the account number reflected in the credit report can be easily reviewed.
How the concept of credit works for credit cards:
You must all know, what a credit card is? it’s a product offered by banks against your credit limit which can be utilized for the purpose of any making any purchase, cash withdrawal, balance transfers form one account to other account and so on.
As soon as, you request for credit card, you are issued a credit line which is basically the maximum limit which can be set in your card account based on your repayment capacity. Most commonly credit card and charge card are used interchangeably though both of them are not the same. Basically, a charge card requires you to completely pay off your balance each month, however in a credit card you can carry forward your balance for a longer time and just need to ensure a minimum monthly balance payment to avoid penal charges, but the Banks would be more than happy to collect interest at a considerably higher rate on the overdue amounts.
Usually, the amount that is due in your credit card is liable to an annual percentage rate (also called as financial charge). Different companies may have different terms and conditions for different types of cards. The charges may depend on your credit score and the type of purchases that you are going to make through it.
Let’s say, for a purchase you might be charged at the rate of 7.5%, and for a cash withdrawal you are charged at 19.5%, for balance transfer at 10.2%. So, credit card charges depend on type of transactions that you are going to make through it.
Credit scores are very important parameter to decide your credit limit and it also indicates how likely you would be able to make repayments of all your outstanding borrowings. As we discussed above, different credit bueros may offer diffrenet credit scored for the same consumer based on the details available with them and the method of calculating credit scores. But, most oftet these score are nearly the close to each other as all these organisations follow a standered method for their calculation.
So, the greater your score is, higher would be the chances to get your loan approved. On the other side, a lower score may let your application get rejected as more risk is considered to be involved with lower credit scores.
How to develop a good credit score
Now that we know how credit works, a good credit score is a combination of your timely repayment history clubbed with your lower utilization ratio. A credit history is extremely important to have a better credit score and if all the repayments were made within the due dates and the line of credit wasn’t utilized much, you automatically would have a good credit score. So, maintaining a maximum utilization of 30 % across all your credit cards would ensure that your credit score doesn’t go sown much.
Why timely repayment of dues is important?
Your repayment history factors a large percentage of weightage in deriving your overall credit score. So, if you are making consistent payment on time, you are definitely going to achieve a higher credit score.
Alternatively, if you are not paying off due within the given time, you would drastically reduce your credit score.
How utilization ratio affects your credit score?
Your overall utilization also heavily contributes in deriving your credit score. So, greater is the debt, higher would be the negative effect on your personal finance and credit score. Utilization closer to the credit limit would signify higher debt, increased risk and downfall of credit score.
Rethink before you apply next for a new loan:
Applying loan for multiple times or even twice in six month may impact your credit score negatively. So, don’t apply credit in any form like personal loan, credit cards, mortgages, quite frequently. Knowing how credit industry works would extend more opportunities for you in future.
Inquiring your credit scores too often also results in decreasing your overall credit score.
As, it is expected that you are interested in knowing your credit score only when you are looking for a advances and so your credit scores are brought down considering your financial instability and risk factors.
Public records also play an important role in deriving your credit score.
If your have any history of a debt which was filed in court or anything like tax liens on your credit profile can drastically pull down your credit scores.
The credit score would almost die down if bankruptcy is filed against any person.
A person with a history of bankruptcy are not likely to get any credit from banks and financial institutions. However, maintaining a proper financial record for a decade or so would defiantly help in increasing trust and will move credit score figures gradually upwards.
Is there any way to improve your credit score?
If you already have a not so good credit score currently, don’t lose hopes. You should now only be careful in paying your outstanding due in time. Also, try to lessen the use of credit cards quite often and maintain a lower utilization ratio (not greater than 30 % in each credit account). Overexerting the limit or bringing utilization closer to the credit limit would still continue to deteriorate your credit score.
Periodic review of your credit health:
In the current world, it’s quite possible to easily find your credit score through various free or paid credit checking applications. These applications may request you to sign-up once for tracking your credit report periodically. Most of these also offer a detailed credit heath report which contains all your borrowing details or any payment which is missed in past, number of account you hold and all-important details which are important for analyzing your credit score. They also offer some expert advices as to how you can increase your credit score eventually.
Monitoring your credit score upfront is extremely important if you planning to avail a housing loan or mortgage in near future.
Hope this article would help you to understand how credit works to maintain a cleaner credit record and live a respectful life.