What Is A Credit Score?

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.

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[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.