You likely have heard of the term credit score however, can
you explain what it is and how it’s derived?
Most people typically can’t explain how a credit score is derived or why
it’s used, including those working in professions that rely on credit scores to
deliver products.
A credit score is a statistical method of assessing the
likelihood that a borrower will pay back a loan. The process originated in the 1950s by a
company called Fair Isaac. The scoring
method became widely available in the 1980s and was used exclusively by the
bank card and auto industries. In the
1990s, credit scores were determined to be a reliable predictive source for
mortgage performance as well.
There have been several names attached to credit scores
based on the company responsible for computing the score. The Empirica Score is affiliated with Trans
Union, the Beacon Score is affiliated with Equifax and the Experian/Fair Isaac
Model is affiliated with Experian.
Scores range from 375-900 and are of virtually the same design at each
repository.[1]
For instance, a credit score of approximately 700 indicates
an approximate ratio of 123 good loans to 1 bad loan, while a score below 600
indicates a ratio of approximately only 8 good loans to 1 bad loan. Therefore the predictive power of the credit
score has been deemed to be very important for industries relying on the credit
worthiness of their customers, including banks, mortgage companies, insurance
companies and companies providing consumer credit. In fact the insurance score, used to assist
underwriters in assessing the risk associated with a specific client, relies
very heavily on one’s credit score.
There are five key predictive variables that are analyzed to
develop a credit score.
·
Previous Credit Performance (This is the most
predictive variable in the computation)
·
Current Level of Debt
·
Time that Credit has been in Use
·
Pursuit of New Credit
·
Types of Credit Available
No one variable determines the score without consideration
to all of the other variables.
Therefore, each category matters in predicting behavior. The more recent the derogatory report
relating to one’s credit, the more risk is assigned. If one has maxed out on a credit limit, a
higher risk is assigned. If one has
pursued multiple sources of credit evidenced by an abundance of inquiries to
credit agencies, more risk is assigned.[2]
The types of credit also play a role. If
you have established credit, that is actually a good thing, however, too much
credit can be bad. It’s not a good
situation for your credit score to have no credit history however, while it
might be positive to have 2 or 3 credit cards, it might not be a good thing to
have 7.
So a credit score can play a vital role in your ability to
gain access to many financial and insurance related products. While it may be quite obvious to most that a
credit score is relevant for a loan, it is not widely known that the credit
score is also used to predict risk in the insurance industry. For instance, if one has a poor credit score,
it will certainly play a role in how an auto or homeowner’s policy is priced
and ultimately if it is issued. That’s
because the insurance score, which also analyzes past losses and frequency of
losses, puts a heavy weight on the credit score as well.
Credit scores are easy to obtain, computer generated and
fair. There is no consideration given to
race, nationality, religion or any other protected class. As a result of the most recent financial
meltdown and the resulting foreclosures and personal bankruptcies, it’s likely
that the credit scoring model will continue to receive scrutiny as time moves
forward.
So now you know more than most professionals know about
credit scores. While they are sometimes
controversial, they continue to play a vital role in the decision making of
many business transactions.
[1]
The Credit Score methodology has been challenged during recent years and some
of the calculations and scoring originally set could have been altered.
[2] If
inquiries are related to the purchase of a new car or a new home, multiple
inquiries are less of a factor.
Additionally, more recently, regulators have required credit agencies to
allow consumers to be able to review their credit report more frequently without
a malicious effect on the credit score.
