How Credit Rating Works ?

It may seem like the banking business is about money. However, the banking business is really all about information. Until banks have the required information about a prospective borrower, they cannot ascertain the risk and make the loan. This is where credit rating comes to the rescue. It this article, we will have a closer look at how the process of credit rating works.

The Need for Credit Rating

In order for the banks to be able to make loans to different individuals, they must have information about the credibility of these individuals. The information they require is firstly regarding the intent of the borrower to pay back the loan and secondly regarding the ability of the borrower to do so. The ability can be gauged partially from the income of the borrower.

In order to completely understand the borrower’s ability to pay back the loan, banks need to know if the borrower currently has any other loans outstanding. Also, the borrower’s previous repayment records provide considerable information regarding his/her intent to pay back the loans.

In the absence of any organized way to collect information about prospective borrowers, the banks would have no way to make loans to anyone apart from a handful of people whose records they already have.

Therefore, there is a need for an agency that aggregates information from all the various banks and financial institutions and provides it back to the banks.

The Idea of Credit Rating

Credit rating companies perform precisely the above mentioned task. They do not work for any individual bank. Rather the agency is formed by the co-operation of all the banks in the banking system.

Every member bank provides data regarding the loans and repayments of its customers. This data is then sorted based on the unique identification provided by the customer such as social security information or driver’s license number.

Therefore if an individual borrows from multiple banks, the information regarding these multiple loans is available in a centralized repository and can be accessed by member banks for a fee.

The basic idea is that the reach of the banking system as a whole is huge. Therefore, an individual bank may not have enough information about a prospective borrower. However, if information from multiple banks is pooled, odds are that there will be enough information available to make an informed decision.

Credit Rating is Not a Measure of Wealth

It is easy to get confused regarding what exactly is measured by credit scores. Credit scores do not monitor the wealth of individuals. In fact extremely rich celebrities like Michael Jackson and Mike Tyson had extremely poor credit scores.

Instead, credit scores represent the timeliness with which a person pays their bills. Therefore, if we have a millionaire who is late on paying his/her bills, they may have a lower credit rating than a middle class person who always pays his bills on time.

Credit Rating Point System

The credit rating process creates a score which is often called as the credit score or the FICO score (named after First Isaac Corporation) which invented the algorithm behind the score. Any person who reaches the age of 18 gets a default FICO score. Therefore, everybody regardless of how rich or poor they are start with the same score.

Every time a payment is made on time, a small addition is made to the score. Also, each time that a payment is missed or delayed, a small deduction is made from the score. This addition and deduction happens dynamically over a period of time. Therefore, at any given point of time, a person has a score which is anywhere between 300 and 900. The higher the score is, the more creditworthy the person is.

However, the score is only built if a person takes out loans and repays them. On the other hand, if a person does not obtain any loans in their entire life, they will have a default score and may not qualify for loans in the future. Critics of the system find this arrangement unacceptable. The “borrow today so that you can borrow in the future” logic seems illogical to many.

However, banks and other lending corporations use the FICO score to make loans. People with higher scores are offered better interest rates and are called prime borrowers. The others are charged an interest premium and are called subprime borrowers.

Major Credit Rating Agencies

Banks conduct a credit check on anyone that applies for a loan. This credit check entails querying of the past payment records in order to find out if there are any missed payments or loans defaulted upon. There are three major agencies that have the technology to enable banks to check credit almost instantaneously. These agencies are Equifax, Experian and Trans Union.

These agencies also allow borrowers to have access to their own reports. Therefore, in case the borrower wants to check their credit rating or dispute some of the charges in their credit rating.

Information That is Not Included in the Credit Report

Individuals have a right over information regarding them. Hence, any bank needs to be authorized by the individual before they can conduct a credit check. Also, certain information is omitted from the reports. The information that is not included is as follows:

• Information regarding the race, sex, ethnicity, religion, political affiliation or any other information which would enable discrimination

• Reports regarding debts which are more than 7 years old

• The amount of money in your savings accounts

• Bankruptcies which are more than 10 years old

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.