Credit Scores Helping Lenders Estimate Potential Risk Finance Essay - Free Essay Example

Sample details Pages: 4 Words: 1248 Downloads: 5 Date added: 2017/06/26 Category Statistics Essay Type Argumentative essay Did you like this example? Credit scores is a grading of an individuals ability to repay debts and arising financial obligations within a specific time limit; its an evaluation of a person or business credit worthiness. It a tool normally used by firms and business that engage in lending activities i.e. banks, mortgage firms, insurances firms and guarantors among others. Don’t waste time! Our writers will create an original "Credit Scores Helping Lenders Estimate Potential Risk Finance Essay" essay for you Create order Credit scores have enabled firms, business, banks and other lending institutions to have vital information regarding their customers creditworthiness and therefore enable them to determine the kind of loans to issue them and the level of interest that can be charged to each borrower, it also enables them to reduce risk that are associated to each of the borrower. Credit scores are normally prepared by the lenders or by independent agents on behave of persons, firms, business and various debt issues. I agree to the idea that credit scores are a fair measure that helps lenders estimate potential risk. Lenders use these scores in calculating the amount of risk that are imminent; they also use it to minimize the level of risk and do evaluate who is eligible for a loan and at what level of interest. Lenders are in an aim of maximizing profit, and for this objective to be achieved, it is dependent on the amount of funds that have been borrowed. Lenders now are faced with dilemma; they have to lend much to earn more, but this objective is subject to the potential risk from borrowers they he have to use credit scores to evaluate which among the customers can bring much revenue, the use of scores before allowing one assess loan is a way of minimizing risk. An important function of credit scores is ensuring that those who borrow loans have the ability to repay as it due and therefore evaluate the confidence level a lender has on the borrower. According to Kerr Duncan (2008) individuals credit worthiness can be known through various aspects including the stock exchange market, financial records and transactions between other players in the credit sector, it is then used in projection of ones behavior in the future. An individuals credit score is an outcome of the various successive independent evaluation of his or her ability to meet outstanding obligations within the set time; it considers borrowing and repayment records, assets and liabilities held by a business. Information is derived from ones history financially to forecast how the same individual is likely to replicate the same in future. It is noted credit scores of persons keep changing either to betterment or otherwise depending on ones economical situations. Credit scores has been a better tool in dealing with the risk faced by lenders, it provide a better solution to the future risk in that most lenders will be having records of every borrower and their scores. It enable lenders determine the appropriate loans and the corresponding interest rates that can be offered to a borrower. Borrowers with poor scores will be avoided or if they are accepted their interest rates shall be punitive to gather for the high risk associated with them. Borrowers can improve their credit scores by paying the arising obligation on loans on time, ensuring that credit balance on credit cards are low and paying off debt rather that shifting them between credit cards. If one always pays his debt obligation within the credit period then he or she is likely to have a favorable credit score. With a good credit score one is likely to have favors from lenders i.e. risk against the lenders will be that low and the borrower can have relatively low finance charges. If an individuals credit score is poor may be because he or she normally defaults or meet arising obligations late, he or she is more likely to have unfavorable terms of credit, to the lender the risk is high and more likely to place high finance charges or even deny the borrower fully. For the credit scores to be more effective tool, methodologies used in calculating needs to be clearly spelt out. It should be noted out that the main role of credit scores is to criticizes and provide useful financial information on individuals, businesses and corporations that can be used to predict the future defaults and therefore averts damage. Credit scores firms need to be flexible and fit to the changing independent market. Kerr (2008) has that independent credit firms must flex to avoid market turmoil, and that credit score firms should develop and use models that touches all the necessary variables making the score. Firms owe to use comprehensive models to ensure the cases of defaults are reduced significantly. To ensure that credit scores are effective credit score firms themselves need to be effective and relevant to the point; they owe to continuously reform themselves to be at par with the dynamic financial market and hence the need to review the methods of calculating credit scores. In order to ensure that credit rating firms are effective in their scores, they should be held liable and accountable to the lending institutions, they can either take the whole liability or to the extent to which they are liable. There are several ways of evaluating a credit score and one famous is FICO- initially called Fair Isaac Corporation. FICO is used by most lending firms to evaluate the possibility that a customer will default. Research as proved scores as predictive in dealing with risk and uncertainty of borrowers; it has shown that most credit consumers have gained from the lower finance cost from credit firms merely due to credit scores. Although there have been critics to the credit rating firms, they are playing an important role ensuring that lending institutions get the valued information. At times the firms developing the credit score use outdated models that do not capture the current changing trends in financial markets therefore placing the lending institutions at risk. Such models have to be reviewed and developed to catch up with the new markets. In some situations credit firms have been said to collude with borrowers to defraud the lenders, such cases have to be dealt with accordingly to ensure such practices do not deter the objectives of credit scores. Even though many lenders use the FICO scores while making decisions on lending, they dont feel satisfied thus they employ their own strategy including evaluating the amount of risk associated with certain products, no unitary score is purely used but several are combine to meet a firms expectation. In conclusion credit scores are a fair measure in estimating potential risk from defaulters, as its seen; its contributing largely to the development of the lending institutions, boosting the confidence of those investing in the credit sphere. Credit scores minimizes the chances of future risk based on just scores but the same scores do not explicitly say that an individual is good or bad. With the shortage posed by the scores, it can be improved by developing a credit model that is effective and relevant in all the sectors and that can greatly help improve in averting defaults. The availability of scores has enable banks to know who qualify to have a loan and what amount at what level of interest rate. It seen also that credit scoring is beyond banks to consumer credit and landlords. The scores have seen firms come together and share information on customer creditworthiness and therefore it can be said that credit scores have been helpful in fighting risk.