Credit Scoring Models

As a young or middle-aged couple with a family that may have taken on some amount of debt, you should always know about what your credit score is. More importantly, you need to understand what a scoring model is and how it is used to determine your credit score and rating.

Credit scoring models are methods used by credit bureaus to evaluate your worthiness to receive credit. They are patterns of analysis used to select certain statistical characteristics found in a person’s credit payment patterns.

While there are many different types of models, the majority of the largest credit reporting agencies – Experian, Equifax and Trans Union – use, the Fair Isaac Company (FICO) model.

Scoring calculations are typically made based on payment record, frequency of payments, amount of debts, credit charge-offs and as amount of credit cards held. A certain weight is assigned to each factor considered in the model’s formula, and a credit score is assigned based on the evaluation. Scores generally range from 300 on the poor end to 850 on the top end.

A high credit score can reward you with lowered interest rates for credit cards and loans and with more favorable term lengths for loans. A low credit score can make you ineligible for those low rates and more favorable terms. Indeed, a low score can be considered enough of a credit risk that a future employer, or even utility company, may make a negative decision regarding your potential employment or receipt of services on.

In addition, your credit score is utilized by an increasing number of institutions to make real-life decisions about your ability to purchase a home or car, pay for appliances or even transact business in your name.

Nearly 75 percent of the lenders and mortgage institutions and more than 90 percent of U.S. credit companies use credit scoring to determine exactly what amount of credit and how much interest to charge an applicant. In recent years, insurance companies began relying more on an applicant’s credit score as a factor in setting insurance rates.

2 Types of Credit Scoring Models

While there are a number of credit scoring models utilized to determine a person’s credit worthiness there are essentially two distinct types of scoring models that can be validated statistically.

These models will either use a statistical or judgmental scoring analysis. In each case, the end credit score result can vary as well.

A statistical scoring model utilizes multiple factors from one or a number of credit reporting agencies, correlates them and then assigns weights to each factor.

The model does not consider the individual judgments or experiences of any credit officials.

A judgmental scoring model considers a person or organization’s financial statement, payment history, bank references and even the credit official’s own previous experience in handling its products and services.

By including these elements in someone’s credit history, a subjective judgment is given more weight in determining the credit score.

Scoring Models Keep Secrets

Companies who develop scoring models prefer to keep details of the models behind closed doors because they consider them privately held and because they make money by selling results of the models. However, given the information that banks and credit card companies ask on their applications, it is not difficult to interpret what factors the models value.

Credit scoring model practice changes

Credit scoring models were first utilized in the credit industry more than 50 years ago. They were developed as a way to determine a repeatable, workable methodology in administering and underwriting credit debt, residential mortgages, credit cards and indirect and direct installment consumer loans.

Early models were based on a greater degree of subjectivity rather than statistical analysis, and those resulted in discriminatory and fraudulent loan and credit practices. Over time, a number of state and federal protections were put into place to reduce the subjectivity and make the process fair, equitable and transparent.

Two of them are the federal Fair Credit Reporting Act and the Equal Credit Opportunity Act, which outlaw the consideration of marital status, race, religion or sex as factors in making credit-scoring decisions.

Benefits of credit scoring models

With the improvement in credit scoring efficiencies, a family applying for a first home, a new car or an extended credit limit does not have to wait an excessive amount of time for a decision. In fact, the consistency of data in scoring models allows for financial statements, credit ratings, credit account statuses to be evaluated quick and for the possibility for human error in to be reduced.