How does a credit check work?
Especially when taking out a loan, the term credit check comes up again and again. But what does that mean? As the name suggests, your credit rating is determined. Creditworthiness is derived from the Latin word “bona”, assets or “bonitas”, excellence.
In the financial sector, the credit check describes the determination of whether a person or a company can repay its debts and has the will to do so. This results in the distinction between personal and economic solvency.
- Personal creditworthiness describes the reliability of a borrower, for example based on his or her current employment or assets
- The economic creditworthiness is a forecast of the solvency that results from past economic activities, for example through loans that have already been repaid
So lenders are concerned with determining the likelihood that a borrower will be able to repay their debts.
When is the creditworthiness checked and which data is important?
The creditworthiness of a potential debtor is checked especially in the context of credit transactions in connection with banks. However, the solvency is also determined, for example, when taking out a cell phone contract or buying in installments in a mail order company.
When issuing loans, the credit check is required by law . Without such a determination, a bank may not grant a loan. Nevertheless, the legislature does not prescribe precisely formulated creditworthiness criteria that credit institutions have to adhere to. On the whole, however, all banks and credit bureaus are based on similar factors that play a role in the credit check:
- Information on income and expenditure (salary, household bill)
- Loans already repaid
- Loans currently in progress
- financial situation
- Soft negative features, such as reminders due to late payment
- Hard negative features, such as personal bankruptcies or foreclosure measures
- In rare cases, geodata (e.g. the current place of residence) are also included
Banks use these data to determine the probability of default. This describes how likely it is that a debtor will be able to meet its claims. Simply put, a bank wants to be as sure as possible that it will get the money it lends back to you.
What do Credit bureau and other credit agencies have to do with the credit check?
Banks work with so-called credit bureaus to determine your creditworthiness. These are private companies that collect a lot of the above data, which are considered as creditworthiness criteria. However, the data recorded there is only made up of current and past credit transactions, soft and hard negative characteristics, and in some cases geodata. A credit agency does not collect information about a person’s income, expenses or assets. The data comes from contractual partners such as banks, mobile phone providers or mail order companies.
From all this information, credit agencies determine a score. This is to describe the probability of default when borrowing a private individual. Banks base their lending on this value on the one hand and on the other hand on your information regarding your income and expenses and other collateral.
Why is a credit check useful?
Although the rather non-transparent procedures of the credit bureaus are often criticized by consumer protection, creditworthiness checks are not without reason. The legislator prescribes this procedure so that both creditors and debtors are protected.
It is useful for the lender to determine the creditworthiness so that they have the security of reliably getting their borrowed money back. Such procedures protect borrowers from potential over-indebtedness. A credit check should not be something that you as a consumer should fear. It shows you whether a future business really lies in your financial possibilities or whether you should better refrain from it. In addition, a proper credit check can also provide advantages, for example when looking for a new rental apartment.