Lenders will use a credit scoring system to measure how likely you are to make payments on the money you borrow. A credit scoring system is created by assigning scores to various attributes associated with the borrower’s creditworthiness. A credit score is very different from the credit scoring model. In a credit scoring model, the probability of default is presented in the form of a credit score. The higher the score, the lower the probability of defaulting on a loan.
There are pre-existing models of credit scoring, but it is not uncommon to find some financial organizations establishing their credit scoring model. However, most tend to use a third-party professional service such as the Fair Isaac Corp.’s credit scoring system, AKA FICO Score. The FICO score is the most prevalent model available. FICO’s scoring system will assign a numerical representation of the creditworthiness with a range of 300 to 850; the higher the number, the higher the individual’s credit score.
Factors Affecting Credit Scoring
Several factors determine and shape the credit scoring models; however, different types of loans may involve different credit factors that are tailored to the loan characteristics.
For instance, the credit factors for a credit card loan may include payment history, age, the number of accounts and credit utilization. On the other hand, the credit factors for a mortgage may include; down payment, job history, and loan size.
Lenders will take into account these factors to determine how much risk as a borrower you present on them should they decide to lend you money. These figures are risk-based.
If you have a low credit score, that means you will be required to pay more to borrow money to finance your project than someone with a higher credit score. While the credit scoring models have their own established guidelines, at times, individual lenders may determine the level acceptable and how much to charge in interest.
How Credit Scoring Works
Five categories are influencing the credit score are;
- Payment history.
- Type of credit.
- New credit.
- Current debt portfolio.
- Length of credit.
The credit scoring models differ slightly in how they score credit. While FICO Score is the most common type of credit scoring model, there are others like VantageScore, which was created by the three credit reporting agencies- TransUnion, Experian, and Equifax.
For transactions involving huge risks, lenders will use a credit scoring model in which the terms of the loan, including the interest rates offered to borrowers, are based on the probability of repayment. As mentioned before, the better the score, the better the rate offered by the lender.
How is it Calculated?
Since the banks use the credit scoring models to give out loans, this means to come up with the scores; there has to be a combination of both qualitative and quantitative analysis. Credit scoring models are based on statistical methods, which enable banks to predict the probability of a particular event occurring in the future, and in this case, loan default.
The scoring process analyzes the information about the customer, which is collected at the application stage. The information collected at this stage mainly characterizes the customer behavior, both in the present and in the past.
Each of the credit institutions will consider a different set of features and will assign different point values on them. For instance, a highly educated person will have a higher score than a college dropout; however, the exact point value and the impact it has on the final score will vary from bank to bank. The total of the points from different characteristics is usually the final score.
What are the types of credit scoring?
The scoring models can be classified according to different criteria. Therefore, we can talk about the scoring of individual borrowers or companies or credit cards, cash, or mortgage scoring depending on the type of product applied for by the client.
On the other hand, taking into account who created and managed the scoring model, we can talk about the internal scoring (based on the bank needs and preferences) or external scoring (created and made available by the specialized institutions).
What you need to understand is that there is a fine line between application and behavioral scoring. Application scoring is designed to evaluate new customers based on the data they provide in the credit application.
Behavioral scoring is assigned based on the history of the customer’s behavior concerning the service of financial products. Thus, behavioral scoring is calculated for regular customers, mainly to resell new products or change the terms and conditions of existing products, for example, increasing the credit card limits.
While for the most part, the goal of a scoring model is to determine the probability of default, more emphasis recently has been placed on using this method for other purposes such as;
- Profit maximization.
- Increasing the effectiveness of marketing campaigns by investigating whether the customers will be interested in a given product or service.
- Fraud scoring.
- Attrition scoring.
- Improving debt management by determining whether the customer can repay the loan in the event of financial hardships.
Regardless of the type, the scoring models help in an objective analysis of the credit risk, which is a crucial element of the credit-granting process. To make the credit calculation as accurate, transparent, and low-risk as possible, banks continually automate these calculations and use ready-made systems that make possible credit assessment model in a point system.
Using such tools helps in the reduction of the probability of granting doubtful loans and helps in accelerating the entire credit process while reducing the risk of human error.
Credit scoring Vs. Credit Rating
Credit rating should never be confused with credit scoring. While the two concepts appear very similar, they are not. Credit rating will apply to companies, sovereigns, sub sovereigns, and those entities’ securities as well as the asset-backed securities.
While the credit scoring models depict a picture of your relationship with the credit and the scores vary between the three main credit bureaus, a credit rating, on the other hand, will determine both the interest rate for the repayment and if the borrower will be approved for a loan of credit or debt issue.
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Disclaimer: The views and opinions of Eric Lawrence Frazier are his own and do not necessarily represent views of First Bank or any organization affiliated with Eric Lawrence Frazier, or the Power Is Now Media Inc. First Bank is an Equal Credit Opportunity Lender. Eric Lawrence Frazier MBA is also a Vice President and Mortgage Advisor with First Bank. NMLS#461807 and a California Licensed Real Estate Broker DRE# 01143482. Email: Eric.email@example.com. Ph: 714- 475-8629.
Eric Lawrence Frazier MBA
President and CEO
The Power Is Now Media Inc.