What is Credit Scoring?

Credit scoring is a statistical analysis performed by lenders and financial institutions to access a person's creditworthiness. Credit scoring is used by lenders to help decide on whether to extend or deny credit. A person's credit score is a number between 300 and 850, 850 being the highest credit rating possible. A credit score can impact many financial transactions including mortgages, auto loans, credit cards, and private loans.

A credit score is influenced by five categories—payment history, types of credit, new credit, current debt and length of credit. A person needs to pay special attention to current debt and payment history.

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What Is A Credit Score?

How Credit Scoring Works

Credit scoring models may differ slightly in how they score credit. Fair Isaac Corporation's credit scoring system, known as a FICO score, is the most widely used credit scoring system in the financial industry. However, another popular credit scoring model is VantageScore, which was created by the three credit-reporting agencies—TransUnion, Experian, and Equifax.

Key Takeaways

  • Credit scores determine a person’s ability to borrow money for mortgages, auto loans, and even private loans for college.
  • VantageScore and FICO are both popular credit-scoring models.
  • Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment.
  • Credit rankings apply to companies (business) and governments and credit scoring applies to individuals.

Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment. In general, the better a person's credit score, the better the rate offered to the individual by the financial institution.

Credit Scoring vs. Credit Rating

A similar concept, credit ratings, should not be confused with credit scoring. Credit ratings apply to companies, sovereigns, sub-sovereigns and those entities' securities, as well as asset-backed securities.

As a traditional approach to credit risk analysis, credit scoring is most effective for small owner-operated businesses and individuals.

Credit scoring models make up a picture of your relationship with credit and scores will vary (although usually not drastically change) between the three main credit bureaus.

A credit rating determines both the interest rate for the repayment and if the borrower will be approved for a loan of credit or debt issue.

Special Considerations

Although credit scoring ranks a borrower's credit riskiness, it does not provide an estimate of a borrower's default probability. As an ordinal ranking, it only assesses a borrower's riskiness from highest to lowest. As such, credit scoring suffers from its inability to determine whether Borrower A is twice as risky as Borrower B.

Another interesting limit to credit scoring is its inability to explicitly factor in current economic conditions. For instance, if Borrower A has a credit score of 800 and the economy enters a recession, Borrower A's credit score would not adjust unless Borrower A's behavior of financial position changed.

More advanced methods of credit risk modeling include structural models and reduced-form models.