Definition of credit score
What is credit rating?
Credit scoring is a statistical analysis performed by lenders and financial institutions to determine the solvency a person or a small business operated by its owner. Credit scoring is used by lenders to help decide whether to extend or deny credit. A credit rating can affect many financial transactions, including mortgages, auto loans, credit cards, and private loans.
Key points to remember
- Credit scores determine a person’s ability to borrow money for mortgages, auto loans, and even private loans for college.
- VantageScore and FICO are both popular credit scoring models.
- Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment.
- Credit scores apply to businesses and governments, while credit scores apply to individuals and small businesses operated by their owners.
How credit scoring works
Credit scoring models may differ slightly in the way they score credit. Fair Isaac Corporation’s credit scoring system, known as FICO score, is the most widely used credit rating system in the financial industry, used by over 90% of major lenders. However, another popular credit scoring model is VantageScore, which was created by the the three major credit bureaus: TransUnion, Experian and Equifax.
A person’s credit score is a number between 300 and 850, with 850 being the highest possible score. Credit scores for small businesses, such as the FICO Small Business Scoring Service (SBSS), range from zero to 300.
An individual’s credit score is influenced by five categories:
- Payment history (35%)
- Amounts due (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
A small business’s credit score is based on information in its credit report, including:
- Company information (including number of employees, sales, ownership and subsidiaries)
- Historical business data
- Company registration details
- Summary of government activities
- Company operational data
- Industry Classification and Data
- Public deposits (privileges, judgments and Uniform Commercial Code [UCC] deposits)
- History of payments and receipts
- Number of reports and details
Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment. In general, the higher the credit score, the better the rate offered by the financial institution.
The higher your credit score, the better your interest rate will be.
Credit rating versus credit rating
A similar concept, credit rating, should not be confused with credit rating. Credit ratings apply to corporations, sovereigns, sub-sovereigns and securities of these entities, as well as asset-backed securities, and are rated on a scale of letters. Credit scoring models give a picture of an individual’s relationship to credit, and scores will vary (although they usually won’t change drastically) among the three major credit bureaus. A credit score determines both the interest rate for repayment and whether the borrower will be approved for a credit loan or a debt issue.
Credit rating limits
Although a credit rating ranks a borrower’s credit risk, it does not provide an estimate of a borrower’s probability of default. It simply assesses a borrower’s risk from highest to lowest. As such, the credit rating suffers from its inability to determine whether borrower A is twice as risky as borrower B.
Another interesting limitation of credit scoring is its inability to explicitly take into account current economic conditions. If borrower A has a credit score of 800, for example, and the economy goes into recession, borrower A’s credit score will not adjust unless the behavior or financial condition of the lender. borrower A does not change.
However, FICO attempted to remedy this drawback by instituting the FICO Resilience Index in April 2020. According to Experian, it “is designed to rate consumers based on their resilience or sensitivity to an economic downturn and provides insight consumers most likely to default in times of economic crisis. It can be used by lenders as another input into credit decisions and account strategies throughout the credit life cycle and can come with a credit report as well as the FICO score.
More advanced credit risk modeling methods, including structural models and reduced form models, are used to assess the probability of default. Advances in technology, such as machine learning and other user-friendly computer languages for analysis, continue to scientifically refine the accuracy of credit risk modeling.