What Is Credit Scoring?
Credit scoring is a statistical analysis performed by lenders and financial institutions to determine the creditworthiness of a person or a small, owner-operated business. Credit scoring is used by lenders to help decide whether to extend or deny credit. A credit score can impact many financial transactions, including mortgages, auto loans, credit cards, and private loans.
- 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 ratings apply to corporations and governments, while credit scoring applies to individuals and small, owner-operated businesses.
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, employed by more than 90% of top lenders. However, another popular credit scoring model is VantageScore, which was created by the top three credit-reporting agencies: TransUnion, Experian, and Equifax.
A person’s credit score is a number between 300 and 850, with 850 being the highest score possible. Credit scores for small businesses, such as the FICO Small Business Scoring Service (SBSS), range from zero to 300.
An individual’s credit score is influenced by five categories:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
A small business’ credit score is based on information in its credit report, including:
- Company information (including number of employees, sales, ownership, and subsidiaries)
- Historical business data
- Business registration details
- Government activity summary
- Business operational data
- Industry classification and data
- Public filings (liens, judgments, and Uniform Commercial Code [UCC] filings)
- Payment history and collections
- Number of accounts reporting and details
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 higher the credit score, the better the rate offered by the financial institution.
The higher your credit score, the better your interest rate will be.
Credit Scoring vs. Credit Rating
A similar concept, credit rating, 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, and are graded on a lettered scale. Credit scoring models make up a picture of an individual’s relationship with credit, and scores will vary (although usually will not drastically change) among the three main credit bureaus. A credit rating determines both the interest rate for the repayment and whether the borrower will be approved for a loan of credit or debt issue.
Limitations of Credit Scoring
Although credit scoring ranks a borrower’s credit riskiness, it does not provide an estimate of a borrower’s default probability. It merely 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. If Borrower A has a credit score of 800, for instance, and the economy enters a recession, then Borrower A’s credit score would not adjust unless Borrower A’s behavior or financial position changed.
However, FICO has attempted to address this drawback by instituting the FICO Resilience Index in April 2020. According to Experian, it “is designed to assess consumers with respect to their resilience or sensitivity to an economic downturn and provides insight into which consumers are more likely to default during periods of economic stress. It can be used by lenders as another input in credit decisions and account strategies across the credit lifecycle and can be delivered with a credit file, along with the FICO Score.”
More-advanced methods of credit risk modeling, including structural models and reduced-form models, are used to assess default probability. Advances in technology, such as machine learning and other analytics-friendly computer languages, continue to scientifically refine the accuracy of credit risk modeling.