What is credit and how does it work?
You are most likely already familiar with the concept of "credit" that allows you to purchase items today, and pay for them later over time. It is very useful for expensive items, such as a new house, that you probably would never own if you had to save all of the money first.
So what is credit?
Credit is money granted to you by a lender who agrees to be repaid, usually on a monthly basis. You then get to use their money to purchase the things you want or need, but can't afford to pay for right away. For loaning you the money, the lender expects something in return, not only that you repay the debt as promised, but that you pay something extra which is called "interest".
Money has a "time value" to it; over time (due to inflation) the value of money decreases: what a dollar will buy today is much less than what a dollar could purchase 20 years ago. Since a lender pays you money today in exchange for a repayment of it in the future, the lender loses the time value of that money. Therefore, they are allowed to charge you interest, often referred to as a finance charge. For example, if a lender gives you $10 worth of credit, he or she might expect to be repaid $11 within the next few months. The extra dollar is the interest charged for the loan.
How do I qualify for the loan?
In a perfect world, lenders would loan everyone all the money they need, and everyone would repay their loans as promised. Unfortunately, not everyone repays their loans on time, and some people never repay their loans at all. The lender must be able to determine your ability to repay the loan. This requires that the lender examine your previous loans and payment history, current employment, income, etc. To make this easier for lenders, credit bureaus were established. Lenders report your payment history to the credit bureaus, and they in turn give the information to other lenders. Rather than give them all of the information, the credit bureaus typically provide a summarized credit report or a credit rating score. If you have a good credit history, then you get the loan and the lender charges a reasonable interest rate. If you have had some problems with credit in the past, then you may not get the loan, or you may get the loan but the lender will charge you a higher interest rate because there is a possibility that you may have trouble repaying the loan.
What is a credit bureau?
A credit bureau is in the business of gathering, maintaining, and selling information about consumers' credit histories. It collects information about consumers' payment habits from credit grantors like banks, savings and loans, credit unions, finance companies, and retailers. The credit bureau stores this information in a computer database and sells it to credit grantors in the form of credit reports. When you apply for a new credit card or loan, the credit grantor orders your credit report from at least one credit bureau and analyzes the information to decide whether to grant you credit. The credit bureau charges the credit grantor a fee for every credit report they order.
Although credit bureaus provide your credit report to lenders when you apply for credit, they do not make actual lending decisions. It is up to individual lenders to evaluate your credit report and any other factors they consider important and then decide whether or not to offer you credit.
The three primary consumer credit bureaus
There are three major credit bureaus providing nationwide coverage of consumer credit information in the United States: Equifax, Experian, and Trans Union. Although many national lending institutions report consumer credit information to all three, smaller banks and other credit grantors may report to only one--or even none. Therefore, your credit report from one credit bureau is not necessarily exactly the same as your credit report from another.
What is a credit report?
A consumer credit report is a document that contains a factual record of an individual's credit payment history. Credit grantors are permitted by law to review your credit report to objectively determine whether to grant you credit. There are 190 million credit active people in the United States who have a charge account, car loan, student loan, or home mortgage. As those people pay their bills, most lenders report credit payment information to credit bureaus. So most of the information in your consumer credit report comes directly from the companies you do business with.
What is a credit risk score?
A credit risk score is a statistical summary of the information contained in a consumer's credit report. The most well known type of credit risk score is the Fair, Isaac or FICO score. Sophisticated mathematical processes calculate the score by assigning numerical values to various pieces of information in the credit report. Credit bureaus provide risk scores to credit grantors who use them to objectively evaluate an applicant's credit-worthiness. The score itself is relative and will be viewed differently by creditors depending on numerous factors, including the creditor's risk level, marketing goals, and business practices. Your risk score will change over time as your credit history develops.