Credit scoring is the process used by financial institutions to assess and measure a consumer’s creditworthiness, or ability to pay their outstanding debts. It is based on a numerical formula which takes into account various characteristics of the consumer. Credit scores are used to help lenders determine the terms of a loan, such as interest rate and length of repayment period, as well as whether to approve the loan in the first place.
Overview of Credit Scoring
Credit scoring is the calculation used to evaluate a person’s credit history, and predict their ability to pay back money borrowed. It is based on a numerical formula which assesses several characteristics, such as the borrower’s past payment history, their debt-to-income ratio, current and opened accounts in the past, total amount of borrowed money, and so on. The result is a three-digit credit score which ranges from 300-850. Credit scores are used by lenders to determine the terms of a loan as well as the loan’s approval.
The most common credit scoring system used in the US is the FICO Score, developed by Fair Isaac Corporation. A FICO score is calculated based on factors such as payment histories, amounts owed, length of credit history, and types of credit in use. Credit scoring models developed by other companies such as VantageScore also exist, although they are slightly different.
Components of Credit Scoring
Credit scoring is based on numerical formulae which weigh many different components. The components of a credit scoring system are typically divided into five categories. These are Payment History, Credit Utilization, Credit Mix, New Credit, and Available Credit.
Payment History takes into account whether debts have been paid on time or late, as well as if any payment plans have been established with creditors. Credit Utilization looks at how much of the available balance the borrower currently uses. Credit Mix examines various types of accounts opened by the borrower, such as credit cards, auto loans, and mortgages. New Credit tracks lines of credit newly opened in the past 12-24 months and how much the borrower is paying out of pocket. Finally, Available Credit looks at how much total credit is available to the borrower.
Lenders consider these components when deciding if and on what terms to extend credit, or whether to approve a loan. Additionally, the credit scoring formula may take into account other factors, such as employment stability or income.
Uses of Credit Scoring
Credit scores are used by lenders to determine the terms of a loan, such as the interest rate and length of repayment period. Banks and other financial institutions can use credit scores to assess a potential customer’s creditworthiness, and establish the probability of the customer defaulting on a loan. Credit scores can also be used to open up opportunities for customers with strong credit, such as lower interest rates or rewards-based credit cards.
Credit scores are also increasingly used for more than just loan approvals. Certain employers, landlords, insurers, and other companies often use credit scores to assess an applicant’s stability and dependability.
Real-World Example
Ahmed applied for a mortgage to purchase a new home. His credit score was 750 which placed him squarely within the “excellent credit” category. His lender decided to approve the loan with an interest rate of 3.75%, as the credit score showed Ahmed had a good record of paying his debts. Had Ahmed’s credit score been in the 630-689 range, the lender may have offered him a rate below 4%, but somewhat higher than the rate given due to his strong credit score.
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