Credit Basics: How Banks Price Risk

Credit is simple.  The more likely a borrower is to default on a loan, the higher the likelihood that the lender will lose money on that loan, even with the interest fees.  As a result, lenders often refuse to make loans to risky borrowers or charge higher rates because they know that some portion of risky borrowers will default.

Although this sounds unfair, it’s is simply the lending market at work: pricing the default risk as an implicit cost of making the loan.  The difference in cost can be dramatic.  Two people getting a $200,000 loan on the same house might pay very different interest rates based on their credit histories.  A borrower with a high credit score might qualify for an interest rate of 6% while the less creditworthy borrower might qualify for a 7.5% rate.  This difference of 1.5% in interest rates translates into a higher monthly payment of $250 and adds up to over $70,000 in higher interest payments over the life of the loan.  Just think what you could do with that savings!

Getting Your Credit Score

Although you can get a copy of your credit report for free at www.annualcreditreport.com, you will generally have to pay to get your credit score.  You can purchase this at www.myFICO.com.

Credit Scores: Your Credit History in a 3-Digit Number

Before the advent of the credit score, lenders used to carefully review each potential borrower’s credit file for signs that they would faithfully repay the loan.  As lenders grew in size and volumes of transactions, this personal review process became cumbersome and full of variation.  As a result, methods were created for summarizing all the information in your credit file into a single number.

This credit scores provides a standardized way of comparing the risk that a borrower will default on a loan.  The higher your score, the less risk you present of default, so lenders will be willing to lend to you at a lower rate.  Because not all lenders report to all credit bureaus, the three major credit bureaus may report different credit scores.

The first company to popularize the credit score was Fair Isaac, creator of the FICO score.  Since then, other scores have emerged, but the FICO score remains the most popular.  Regardless of the model used, credit scores are generally between 350 at the low end to 850 at the high end.

How Your Credit Score is Determined

FICO scores are determined by assigning varying weights to five important factors:

1. Payment History (35%)
   Borrowers who are current on their accounts generally have lower default risk.  Delinquencies, late payments, collection actions, and bankruptcies have a major negative impact on your score.  The more recent the delinquency is, the larger the negative impact.  The good news is that by paying on time, your credit score can start to improve in as little as 6 months, although bankruptcies will stay on your credit report for 10 years.
2. Outstanding Debt and Credit Line Utilization (30%)
   This factors in your overall debt levels on auto and home loans as well as how close your credit card balances are to the credit limit.  This last factor, your credit line utilization (total credit card balances divided by total credit line), measures how much of your credit you are using.  Fair Isaac has found that borrowers who use a higher percentage of their available credit are a higher risk of default.  Your credit line utilization should ideally be less than 25% and roughly the same on all cards.
3. Length of Credit History (15%)
   A long credit history gives creditors an idea of your payment actions over a period of time. If you have a short credit history less is known about your risk and therefore creditors conservatively rate you as higher risk.
4. New Credit and Credit Inquiries (10%)
   Opening a new account may indicate that you are taking on debt obligations that you won’t be able to manage or that you are desperate and are relying on credit to meet expenses.  Similarly, applying for credit which shows up as a hard inquiry on your credit report, may indicate that you are about to take on more debt than you can handle.  Soft inquiries from pre-approved offers, current lenders evaluating your credit, landlords, or yourself do not count against your score.
5. Types of Credit (10%)
   Having a mix of different types of credit such as credit cards, auto loans, and mortgage show experience managing different types of debt and this mix will positively impact your score.  Certain types of debt like in-store financing are correlated to higher default risk in borrowers and will negatively impact your score.

Improve Your Credit Score

1. Review your credit report and correct errors.  You can request one report from each credit bureau every 12 months at www.annualcreditreport.com.  Review your report for inaccuracies and request a correction from the credit bureau where it appears.  By law, the credit bureau has 30 days to dispute your claim with the lender.  Remember to keep a copy for your records.
2. Improve your payment history by getting current and staying current.
3. Reduce your credit card balances until your credit line utilization is less than 25%
4. Don’t open or apply for new credit.  Both of these will reduce your credit score
5. Don’t close unused accounts.  Although this sounds counter-intuitive, closing an unused or zero-balance credit card will reduce your available credit line and therefore increase your credit line utilization.  Unless this card has an annual fee, leave it open.

Translate Your Higher Score into Lower Rates

After you have made significant progress paying down credit card debt and maintaining a consistent on-time payment history for 6-12 months, your credit score may have improved dramatically.  At this point, you can translate your higher score into lower interest costs.

1. Lower your remaining credit card rates by calling your credit card company and asking for a lower rate.  They will pull your score and, recognizing that you could get lower rates elsewhere, may offer to lower your rate.  Renegotiating with your current card issuer is always preferable to getting a new card, as the new hard inquiry will lower your score.
2. Refinance your mortgage.  If your score has improved significantly, the savings can be substantial.  Do your mortgage shopping within a 2-week window, as the scoring algorithm treats all hard inquiries within a short period of time as a single inquiry if done for the same type of loan.
3. Take advantage of new balance transfer offers if these have become available to you.  Your credit score will take a hit, but the lower interest costs may justify it and it will rebound quickly as you continue to make payments on time and to reduce credit card balances.

Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs.  DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.