Why Credit Scores Are Used For Loans and Insurance Rates

The current economic crisis means that loan providers and insurers take on greater risks. In order to minimize those risks, they need a more accurate assessment of their clients’ reliability. And this is where credit scores come into play.

What are Credit Scores?

Technically, your credit score is a 3-digit number that is generated by a statistical algorithmic program that factors in various facets of your behavior in regard to your credit. The computation takes into account factors such as your payment history (if you always pay on time, for example) and the amount you owe on your credit accounts. Statistically speaking, the more responsibly you act in response to your credit situation, the higher the credit score you receive.
In essence, the credit score purports to be a scientific, objective and measurable method to determine just how a great a credit risk you are.

Using Credit Scores to Compute Loan Interest Rates

Since credit scores have proven to be an efficient method to determine your ability to pay back loans, loan providers have traditionally been the most frequent users of credit scores. Loan providers include credit scores as part of their evaluation methods, so that they will have an idea of the risk a loan to you represents. If your credit score is high, then the interest rates will be correspondingly low, because you offer a greater likelihood that you can and will pay back the loan on time. With a low score, you will then be penalized with a higher interest rate. Loan providers do not rely on credit scores exclusively, though it is possible that with an extremely low credit score your request for a loan may be denied outright.

Using Credit Scores to Determine Insurance Premiums

It has become more common in recent years for insurance companies (especially auto insurance) to factor in a person’s credit score when trying to compute the annual premium to charge. There is a belief in the auto insurance industry that credit scores are accurate indicators of responsible behavior in general, not just in regard to the payment of credit. In short, more insurers have come to believe that if a person is responsible enough to pay off loans on time, then that person will also act responsibly when behind the steering wheel.

Scientific research actually provides compelling proof to back up this belief. In 2003, researchers for the University of Texas conducted an analysis of almost two hundred thousand policies. It was demonstrated that those people who had lower credit scores represented a greater risk for insurers. They tended to incur auto insurance losses more frequently, and their claims often necessitated higher payouts.

In conclusion, the easiest and most convenient way to avoid being unfairly penalized through high interest rates and high premiums is to simply keep your credits scores high. And you can achieve that by consistently acting responsibly with your outstanding loans.