Credit and the Consumer

While credit stimulates the economy, it does have to be used judiciously. Credit is not money. Derived from the Latin word for "trustworthiness," credit is based on faith that the borrower will repay the debt with real money. One should not use credit in place of money when there is little or no likelihood that payment in real money will be made—using credit without the intent or ability to pay is theft.

Today, credit has become a business in its own right. Credit is issued by banks, savings and loans, credit unions, public utilities, and even merchants. According to the Federal Reserve, there was more than $2.5 trillion of consumer debt outstanding by late 2009—this is more than double the amount outstanding in 1994. This represents hundreds of billions of dollars in interest earnings to lenders. This is why credit card companies aggressively compete to get you to use their credit cards and services. The marketing is so aggressive that consumers may lose sight of the fact that this is not free money and make excessive purchases to the point where they find themselves in financial difficulty.

Creditors take measures to protect themselves from bad debtors, but the profit is so high that creditors tend to take more risk than the average investor can afford to take. Creditors check the credit history of potential borrowers and apply statistical methods to determine how much of a risk a debtor poses. A very popular tool used by creditors is the FICO® score developed by Fair Isaac Company as a credit predictor. There are several consumer credit reporting agencies that collect data about your credit transactions and make reports available to authorized inquiries about your credit history. Many financial advisors recommend that you check your credit reports at least annually to be sure they contain only correct and accurate information. The three major credit bureaus in the United States are:

Equifax
Experian
TransUnion

If you are denied credit or employment based on information contained within a credit report, you are entitled to a free report of the credit report that was used to make the determination of your denial if you request this report within sixty days of the denial. Additionally, you can request a free credit report once every 12 months from each of the three credit bureaus reporting companies at annualcreditreport.com. You should request a report from all three credit bureaus, as they may contain different information about you. Equifax offers a combined report from all three agencies—and consumers can also request a copy of their FICO® score for nominal fees.

Using information from your credit history, creditors use a mathematical credit scoring model that computes the probability of your being a good credit risk. This is a financial profile used to compare you to others of the same profile to determine how much of a credit risk you pose. If your risk profile shows that you are a high risk, you may be denied credit. You may also be denied credit if you have no profile. Some advisors recommend that young adults establish a credit history by making credit card purchases and paying them immediately to generate a favorable credit record.

Credit is an important financial tool that allows consumers to acquire goods and services they need immediately, although they may not have the cash available. It should not be used to make impulse purchases, since the interest and finance charges greatly increase the cost of those purchases. Irresponsible use of credit could lead to financial hardship and may result in bankruptcy.