Credit rating is an important part of consumer finance. The rating influences the interest rate charged on personal loans, borrowings on credit cards and on mortgage loans.
When financial institutions arrange borrowing facilities they consider the possibility that the borrower might default and not pay back the loan. The number of defaults within a portfolio clearly has an impact upon its profitability.
Credit rating scores allow lending institutions to segment their portfolio into groups which has different probabilities of default. The segments can be charged different interest rates to compensate for the different rates of default. Borrowers who are seen as poor risks are typically charged higher interest rates compared to those that have lower risk profiles.
Credit score can also influence whether an institution will accept or decline a loan. Most institutions have a risk threshold and will only accept a borrower with a credit score above a certain threshold. A minority specialise in higher risk lending and specialise in lending, at high interest rates, to borrowers who have lower credit scores.
In practice credit rating scores have been developed by a number of organisations that have researched the factors that increase the risk of default for consumer loans. Equifax is the oldest, and one of the largest, of these credit agencies. Their credit rating score is known as a Beacon score. As with the other credit rating scores the factors that influence the Beacon score is a closely guarded secret. As with the other credit scores, the borrower is given a score between 0 and 999 which represents their credit worthiness. A borrower with a high score above 750 should have no difficulty in raising a loan or mortgage and will be able to chose from the best products on the market. A borrower with a score lower than 600 might find it difficult to be accepted for a mortgage.
Borrowers should naturally be concerned about their Beacon and other credit rating scores and take steps to keep them as high as possible. Freedom of information legislation means that the scores are publicly available even through the rating methodology is not. Clerical errors do occur and can unfairly impair credit ratings so it is as well to regularly check that the ratings match against expectations. The consumer should contact the rating agencies if an error is suspected.
Although the rating methodology is confidential some common sense judgements can be applied to understand the credit rating score. Financial stability, such as home ownership and years within that property are considered favourably. A history of late loan repayments, an excessive number of loans, or a record of borrowing above credit limits is viewed unfavourably.
Borrowing comfortably within credit limits and paying back on time is viewed favourably. At the end of this process the individual score is adjusted to take account of broader market conditions such as the prevailing rate of personal bankruptcies. Sometimes the lender will add their own assessment to the raw information provided by the credit rating score.
As can be seen credit rating scores have an important role to play in consumer finance. A wise consumer should manage the score by paying loans promptly and staying within credit limits. By so doing the consumer will maintain access to lending facilities at reasonable cost.