[bullseye]

> For example, I've paid cash for the last 5 cars our family has purchased over the last 6 years. Why doesn't my ability to do that apply to my credit-worthiness?

Because paying cash once for something is the opposite of proving credit-worthiness. You haven't proven an ability to uphold your end of a long-term agreement.

If you want to improve your credit, finance those cars. Make payments for about 6 months and then pay them off. You pay a little extra in interest, but you get another credit entry which is in good standing.

On an unrelated note, you can almost always negotiate a better price on your car (in the US) if you finance and then pay the loan off.

[morrad]

There are better (less expensive) ways to build credit than car loans.

While I don't remember the name, my wife and I built credit getting some sort of secured loan from our local credit union. The process was something along the lines of making an account with them, putting $X into the account, and then getting a 6 or 12 month loan from them for the same $X dollars at a really low interest rate. Overall I think we paid $30 to $50 dollars over that period in interest.

[unclebucknasty]

>Because paying cash once for something is the opposite of proving credit-worthiness. You haven't proven an ability to uphold your end of a long-term agreement.

This is absolutely true under the current system. But, I think the parent is actually questioning the rationale behind the current system.

I agree to some extent. Accruing, then using significant cash-on-hand to make multiple large purchases should speak more than it currently does to the customer's financial responsibility and/or wherewithal. It's also potentially evidence of his/her earning ability. All of these should contribute more to the determination of a person's "credit-worthiness".

The current system is punitive for those who generally don't like debt, but recognize its necessity for large purchases (i.e. especially for homes). Debt elimination/avoidance is a sound and oft-recommended personal financial practice, which should show sound financial judgement. Why is there a penalty for subscribing to it?

Of course the credit-reporting bureaus profit tremendously by upholding the current system as it is. Their biggest customers as well as their source of information/power are the creditors themselves.

[tedunangst]

Of course the credit-reporting bureaus profit tremendously by upholding the current system as it is.

This doesn't seem to follow. The credit bureau has incorrectly identified a responsible person and denied them a loan. No loan = no interest payments. How do they or the bank profit? People who deal solely in cash are the worst kind of (non) customer for the financial industry. Wouldn't the banks prefer (and pay for) accurate ratings over inaccurate ratings?

[unclebucknasty]

If that denied person then goes off to build a credit profile by engaging in a series of other credit transactions, then the value of that customer grows tremendously for the credit bureau. Each debt becomes a part of his/her profile that can then be sold and re-sold. And each transaction generates revenue for the bureau as prospective new creditors pull the customer's credit. It's a self-serving system that benefits both the creditors and the bureaus. From the bureau's perspective, this is far more profitable than taking into consideration other factors to get just one loan decision "right".

And, this is the how we've been trained to "build credit", as evidenced by the grandparent's standard advice to improve credit by financing cars and paying them off over the months vs. paying in cash. This is how things work currently, and most people understand and follow that program, which suits the bureaus quite well.

>Wouldn't the banks prefer (and pay for) accurate ratings over inaccurate ratings?

This is not to say that the current approach is wholly inaccurate. It certainly can be one way to measure worthiness. I'm just saying that there are other approaches that are overlooked and, as it happens, the credit bureaus don't have much incentive to pursue those other approaches.

[pdonis]

You're assuming that "credit-worthiness" == "financial responsibility", but they're not the same thing, because "credit" as it's used in our current economy is not the same as "credit" as you would think of it just using ordinary common sense.

When you get a loan for a car or a house or pretty much anything else, the bank is lending you money it doesn't actually have. (This is called "fractional-reserve banking" in order to confuse the uninitiated into thinking it is something abstruse, when it's actually very simple: I've just defined it in one sentence.) The cash that gets paid to the seller when you close on the loan is created on the spot (ultimately it comes from the Federal Reserve, at least in the US, which can print money on demand--actually it doesn't even have to "print" it since it's just electronic entries in accounting databases); it doesn't come from the bank's vaults.

So the bank doesn't really care whether or not you can pay back the loan; it makes its money on the "processing fees" at closing. The loan payments you make are going to third parties (in many cases, the bank sells your loan to a third party almost as soon as it's created), who are spreading the risk of default much more widely. (If you ask, "what happens when that risk isn't spread widely enough?", the answer is that you get an economic meltdown such as the one that happened in 2008.) But since the primary lender is making money on fees, it considers people "credit worthy" who generate fees: i.e., who take on debt. It does not like people who pay cash because that creates no debt and hence no fees.

[unclebucknasty]

>You're assuming that "credit-worthiness" == "financial responsibility"

No. I am saying that it doesn't, but should to a larger degree.

>This is called "fractional-reserve banking"

Yeah, I'm pretty well familiar with our banking system. No need for the Dr. Evil-style "laser" air quotes. It's not germane to this discussion in any event, as defaulted loans aren't good for the bank.

>So the bank doesn't really care whether or not you can pay back the loan;

Not true. Many banks/lenders actually service most of their non-real estate loans vs. selling them. Also, to the extent that they do sell loans, they care about credit-worthiness because higher quality loans fetch a higher price.

>(If you ask, "what happens when that risk isn't spread widely enough?", the answer is that you get an economic meltdown such as the one that happened in 2008.)

This is incorrect. In some ways, the problem was that they "spread the risk" too much. That is, the same loans were re-packaged and sold multiple times, creating insane leverage through exotic instruments (derivatives, CDOs, etc.) of little-to-no-intrinsic value. Had we simply seen a series of defaults, the systemic threat would have been greatly reduced. It was the leverage that created the real crisis.

[pdonis]

I am saying that it doesn't, but should to a larger degree.

Ok, fair enough. I agree that it should; but then again I don't think fractional reserve banking is as good an idea as most economists appear to think it is.

It's not germane to this discussion in any event

I think it is, because the fact that making loans causes money to be created on the spot means that loans are cheaper (in some cases, much cheaper) than they would otherwise be. That greatly reduces the incentive to increase one's financial responsibility. Also see below.

defaulted loans aren't good for the bank

They aren't if the bank still owns them and if the bank was booking them at an inflated value, yes.

Many banks/lenders actually service most of their non-real estate loans vs. selling them.

Yes, I should have drawn a distinction between real estate loans and other loans.

to the extent that they do sell loans, they care about credit-worthiness because higher quality loans fetch a higher price.

They care about creditworthiness in the sense of ratings, yes; but I thought we agreed that that's not the same as actual financial responsibility, i.e., as whether the borrower can actually pay back the loan. See below.

In some ways, the problem was that they "spread the risk" too much.

They thought they were spreading the risk by re-packaging loans in all these creative ways, when they actually weren't. (This may be what you were referring to by putting "spread the risk" in scare-quotes. Note that I did not do that in my previous post.) Spreading risk means the risk of any one loan defaulting is independent of the risk of other loans defaulting. That turned out not to be true, because real estate was in a bubble, created by low interest rates and consequent cheap mortgages (and the fact that the money for the loans was being created out of thin air), and when the bubble popped, lots of loan defaults happened that were correlated, not independent.

Had we simply seen a series of defaults, the systemic threat would have been greatly reduced. It was the leverage that created the real crisis.

I agree that leverage greatly exacerbated the problem; but note that the leverage doesn't just come from the derivatives. It comes from fractional-reserve banking in general, i.e., from giving out more loans (up to 10 times as many with the current reserve requirement of 10%) than the actual supply of real savings justifies. That's going to create a bubble in whatever the loan vehicle du jour is, even if no other leveraging is present.