Understanding and Managing Consumer Credit Risk

Consumer credit risk is the risk of loss that is accepted by a lender. The risk is that a borrower will not meet their payment schedule or will default on the credit account. All lenders, such as a mortgage, personal loan, auto loan, credit card and so on must consider consumer credit risk. Companies issuing credit to consumers typically use the credit scores calculated by Equifax, TransUnion and Experian to determine whether to lend to a particular consumer and what the terms of the transaction should be.

Why Consumer Credit Risk Matters

Creditors understand that not all consumers are equally likely to repay their debts. Basic economic principles suggests that interest rates and credit terms must be different because creditors need to compete with each other to attract the best borrowers. Creditors identify the most attractive borrowers by their credit score. The FICO score is the most commonly used metric in the United States. FICO scores is one of the most important factors of credit.

For example, let's assume there are two borrowers with identical demographics, such as age, income and location. If one borrower has good credit and the other one has bad credit, the offers they receive for credit will be very different. They will face very different interest rates. This is extremely important in the mortgage market, for example, because banks list the respective interest rates that they charge for each credit score range. The spread between the lowest and highest interest rates can be large enough that the monthly payment doubles and credit no longer becomes affordable.

Factors Affecting Your Credit Score

Given the importance of a credit score, it is imperative that consumers learn to manage their credit risk to make borrowing affordable. The exact formula that is used to determine a FICO score is a closely guarded secret. However, the components that make up the score have been disclosed:

  • Payment History accounts for 35% of the score. This is the single most important factor that affects an individual’s FICO score. Making payments on time goes a long way toward keeping a credit score high and is the easiest way to improve a bad score.
  • Credit Utilization accounts for 30% of the score. Credit utilization refers to the percentage of available revolving credit is used for debt.
  • Length of Credit History accounts for 15% of the score. The longer you have credit, the more reliable you are, and thus the higher your credit score will be.
  • Types of Credit Used accounts for 10% of the score. Borrowers who use different types of credit, such as installment loans, credit cards, personal loans and mortgages are viewed as lower-risk borrowers.
  • The remaining percentage includes credit inquiries. An inquiry is an applications for credit, they are listed on an individual’s credit report for 2 years. If there are too many applications, a borrower might be taking on more credit than they can afford. It is usually recommended to apply for a limit increase instead of applying for a new credit card because your limit and balance will be in line and will your credit report will not show new debt.
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