Credit Scoring

What is Credit Scoring?

Credit scoring is a statistical method used to predict the probability that a loan applicant or existing borrower will default or become delinquent. The method, introduced in the 1950s, is now widely used for consumer lending.

Using historical data and statistical techniques, credit scoring tries to isolate the effects of various applicant characteristics on delinquencies and defaults.

The method produces a “score” that a lender can use to rank its loan applicants or borrowers in terms of risk. To build a scoring model, or “scorecard,” developers analyze historical data on the performance of previously made loans to determine which borrower characteristics are useful in predicting whether the loan performed well.

Information on borrowers is obtained from their loan applications and from credit bureaus. Data such as the applicant’s monthly income, outstanding debt, financial assets, how long the applicant has been in the same job, whether the applicant has defaulted or was ever delinquent on a previous loan, whether the applicant owns or rents a home, and the type of bank account the applicant has are all potential factors that may relate to loan performance and may end up being used in the scorecard.

How was a credit scoring model developed?

To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness. Then, each of these factors is assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company.

According to Fair, Isaac and Company, Inc., a leading developer of scoring models, 50 or 60 variables might be
considered when developing a typical model, but eight to 12 might end up in the final scorecard as yielding the most predictive combination (Fair, Isaac).

In a scoring system, higher score indicates lower risk, and a lender sets a cutoff score based on the amount of risk
it is willing to accept. Strictly adhering to the model, the lender would approve applicants with scores above the cutoff and deny applicants with scores below (although many lenders may take a closer look at applications near the cutoff before making the final credit decision).

Who uses credit scoring?

In the past, banks used credit reports, personal histories, and judgment to make credit decisions. But over the past several decades, credit scoring has become widely used in issuing credit cards and in other types of consumer
lending, such as auto loans and home equity loans.

One Federal Reserve survey in 1996 reported that 97 percent of the responding banks that use credit scoring in their credit card lending operations use it for approving card applications.

Credit scoring is also becoming more widely used in mortgage origination. Both the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Corporation (Fannie Mae) have encouraged mortgage
lenders to use credit scoring, which should encourage consistency across underwriters.

Benefits of credit scoring

Credit scoring has some obvious benefits that have led to its increasing use in loan evaluation.

First, scoring greatly reduces the time needed in the loan approval process. A study by the Business Banking Board found that the traditional loan approval process averages about 12-1/2 hours per small-business loan, and in the past, lenders have taken up to two weeks to process a loan. Credit scoring can reduce this time to well under an hour, although the time savings will vary depending on whether the bank adheres strictly to the credit score cutoff or whether it reevaluates applications with scores near the cutoff.

This time savings means cost savings to the lender and benefits the customer as well. Customers need to provide only the information used in the scoring system, so applications can be shorter. And the scoring systems themselves are more cost-effective.

Another benefit of credit scoring is improved objectivity in the loan approval process. This objectivity helps lenders ensure they are applying the same underwriting criteria to all borrowers regardless of race, gender, or other
factors prohibited by law from being used in credit decisions.