Credit Basics
The Purpose of Credit Reports
By Daniel Muniz

There are a number of consumers who are totally mystified about what credit really is while there are plenty of others who are angry and upset that the financial sector relies exclusively on credit reports and on credit scores. Much of the confusion and frustration stems from the result of having unrealistic expectations that creditors ought to loan money to just about anybody regardless of circumstances.

The bottom line is that if you want to borrow money, you need to have good credit.

No one is going to loan money to a stranger unless there is a reasonable chance that he or she will pay it back. And when there is absolutely no collateral secured, then that reasonable chance of repayment has to be increased even further. It is as simple as that which explains the purpose of why credit reports and credit scores are used. Creditors need to have some way to evaluate your current financial obligations as well as your past performance so that they can make an informed decision about whether or not to loan you money.
 

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As a result, everybody needs to know what credit is and why credit reports and credit scores matter.

In its most basic form, credit is fundamentally a record of your “reported” transactions. This information resides in a credit report which is maintained in gigantic databases by the Consumer Reporting Agencies (CRA) also commonly known as the credit bureaus. The credit bureaus are private for-profit companies who collect your credit data from your creditors and then sell it to the lenders (and they also sell it back to you).

Your creditors provide the credit bureaus with your information about the accounts you have with them. This data includes the essentials such as the type of credit you have, loan amount, payment history, etc.

But the key point to emphasize is that your credit report contains only “reported transactions” so it is very likely to have a credit arrangement which could does not show up on your credit report.

Creditors are under no obligation whatsoever to detail your credit activity to the credit bureaus. And there is no federal law compelling them to do so because it is purely voluntary. There are some creditors who do a good job in faithfully updating your credit report to the bureaus every month while others are very sloppy about it. And some rarely get it done right. With sloppy creditors, your only recourse is to take your business somewhere else.

And reporting your credit behavior to a credit bureau is not free.

A creditor has to pay money for a subscription service to each and every CRA and each subscription varies in price and in substance. As a result, some of the smaller creditors may only report your credit behavior to one or two CRAs instead of to all three of them.

But overall, if you paid your bills on time, then your credit report is going to reflect that. If you did a mediocre or even a terrible job managing your financial obligations, then your credit report will also show that as well. The more “good” credit items you have on your credit report, then the better of a credit score you may get. And better scores increases the chances of financial institutions loaning you money with more favorable terms and rates.

The credit score generated by a credit bureau represents a snapshot of your past and present credit behavior depicted as a numerical value. This value characterizes the potential risk that you will not pay off your obligations in a timely fashion. And the higher the score, the less risk involved. The lower the score, the greater risk involved. And a very low score represents the strong possibility that you may not repay anything back.

Naturally, a lot of people are upset that lenders use a credit score to predict the future. Even if you have a crystal ball, there really is no way to accurately predict future events. Instead, this scoring system analyzes your past behavior and present situation and then projects probable outcomes.

And regardless of how fair or unfair this may be, that is the system that is in place now and it has become a fixture in the lending process. As a result, it is in your best interest to understand how the system works and to use that knowledge to exploit its sensitivities.

In the past, consumers were totally in the dark about their credit ratings. In fact, creditors were not even allowed to show anyone their own credit scores. At that time, no one really had an idea what influenced the credit scoring system and the credit bureaus wanted it to stay that way.

State and federal pressure changed all of that. Even though the scoring method is still proprietary, the CRAs were forced to disclose many of the dynamics of how the system worked and what is and what is not taken into consideration when calculating the score. Additionally, the weight of those factors was also revealed.

There is now a plethora of information from reliable sources about how credit works and how credit scores are calculated. If you want the best rates and terms possible for any type of credit, you now have the means to find out what kind of credit behavior will give you the highest possible score. The information is out there but you have to take it upon yourself to become an informed consumer.

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