Credit Scores: How They Work

The process of granting credit leaped forward dramatically when statistical models were built in the late 1950s using debt payment information derived from millions of consumers. Score—model developers identified factors in this consumer payment data that proved to be reliable indicators of future credit performance. They used these factors to create objective models which were highly accurate in predicting whether borrowers would repay debt.

ABOUT CREDIT SCORING 

Your credit score is a fluid number that changes. Therefore, any change to your credit report could impact your score.

Before the advent of credit scores, lenders depended solely on their experience in consumer credit behavior as the basis for granting new credit. Loan committees reviewed each applicant’s personal financial history, using human judgment to determine who would receive credit. 

Credit scored became common in the industry in the 1980s, and today are widely accepted by lenders as a reliable way to evaluate a potential borrower’s willingness and ability to repay a loan. The industry’s use of scoring models have made the credit process quick, efficient and objective, enhancing business and helping consumers get the credit they need.

A credit score is generated from the elements in a consumer’s credit history. Credit scoring condenses a borrower’s credit status into a single number, which changes as elements in a credit report change.  For example, a late payment, the payoff of a loan, or a newly acquired card account could cause a score to fluctuate up or down. The credit score reflects the risk level of lending to a potential borrower, with a higher number indicating lower risk.

Lenders depend on credit scores to predict many things, such as consumer response to direct-mail offers, the likelihood that mortgage holders will default on a loan, or that a consumer will move an account to another financial institution.

Banks, credit card companies, auto dealers, retail stores and most merchants that issue credit or loans use credit scores to quickly summarize a consumer’s credit history, avoiding  the need to manually review an applicant’s credit report.

Many different credit scores are utilized in the financial industry.  A score may be different from lender to lender  or from car loan to mortgage loan, depending on the type of credit scoring model that was utilized. Scores used by individual lenders may use such elements as income, occupation and type of residence in determining their own customer credit. Other factors are included such as an applicants income vs. the size of the loan.

The most widely used score is the FICO score, generated by the Fair, Isaac Company. FICO scores are computed based on data provided by the three main credit bureaus, Experian, TranUnion and Equifax. Scores generated by these bureaus cannot use demographics which are prohibited under the Equal Credit Opportunity Act, such as race, color, religion, national origin, gender, age, marital status, receipt of public assistance or exercise of rights under the Consumer Credit Protection Act.