SCORING FOR CREDIT

 

 

How does a creditor decide whether to lend you money for a new car, a home mortgage, or for some other purpose? Many creditors use a system called "credit scoring" to determine whether you are a good credit risk. Based on how well you score, a creditor may decide to extend credit to you or turn you down. The following questions and answers may help you understand who gets credit - and why.

 

What is Credit Scoring?

 

Credit scoring is a system used by some creditors to determine whether to give you a loan or credit card. The creditor may examine your past credit history to evaluate how promptly you pay your bills and look at other factors as well, such as the amount of your income, whether you own a home, and how many years you have worked at your job. A credit scoring system awards points for each factor that the creditor considers important. Creditors generally offer credit to those consumers awarded the most points because those points help predict who is most likely to pay back the debt.

 

Why is Credit Scoring Used?

 

In smaller communities, shopkeepers, bankers, and others who extend credit often knew by word of mouth who paid their debts and who did not. As some creditors became larger and as the number of their consumer credit applications grew, these creditors need to establish more systematic and efficient methods for evaluating which consumers were good credit risk. Credit scoring is one such technique.

 

While smaller creditors still may rely on informal credit evaluations, many large companies now use formal credit scoring systems. While no system is perfect, credit scoring systems can be at least as accurate as informal methods for granting credit - and often are more so because they treat all applications objectively.

 

How is a Credit Scoring System Developed?

 

Most credit scoring systems are unique because they are based on a creditor's individual experiences with customers. To develop a system, a creditor will select a random sample of its customers and analyze it statistically to identify which characteristics of those customers could be used to demonstrate creditworthiness. Then, again using statistical methods, a creditor will weigh each of these factors based on how well each predicts who would be a good credit risk.

 

How is a Consumer's Application Scored?

 

To illustrate how credit scoring works, consider the following example that uses only three factors to determine whether someone is creditworthy. (Most systems have 6 to 15 factors.)

 

Example

 

Monthly Income	Points Awarded
Less than $400	0
$400 to $650	3
$651 to $800	7
$801 to $1,200	12
$1,200 +	15
Age
21-28	11
28-35	5
36-48	2
49-61	12
61+	15
Telephone in home
Yes	12
No	0

 

 

 

*Some credit scoring systems award fewer points to people in their thirties and forties, because these individuals often have a relatively high amount of debt at that stage of their lives. The law permits creditors using properly-designed credit scoring systems to award points based on age, but people who are 62 or older must receive the maximum number of points for this factor.*