Understanding Credit Scores
For years, creditors have been using credit scoring systems to determine whether a
consumer is a good risk for credit cards and auto loans. More recently, credit scoring has been
used to help creditors evaluate a consumer’s ability to repay home mortgage loans and whether
to charge deposits for utility services. Many auto and home insurance companies use special
credit scores to decided whether to issue a policy and for how much.
Here's how credit scoring works in helping decide who gets credit -- and why.
What is credit scoring?
Information about consumers and their credit experiences, such as bill-paying histories,
numbers and types of accounts, collection actions, outstanding debt, and the age of accounts, is
collected from a consumer’s credit application and credit report. Using a statistical program,
creditors compare this information to the credit performance of consumers with similar
profiles. A credit scoring system awards points for each factor that helps predict who is most
likely to repay a debt. A total number of points--a credit score--helps predict how creditworthy
a consumer is, that is, how likely it is that a consumer will repay a loan and make the payments
when due. The most popular type of credit score is usually between 300 and 850. A higher
number is considered a better score.
How is a credit scoring model developed?
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. Each of these factors is assigned a weight based on how strong a predictor
it is of 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.
Under the Equal Credit Opportunity Act, a credit scoring system may not use certain
characteristics like -- race, sex, marital status,