What Is A Credit Score?

When one banker asks another “What’s the score?” shareholders needn’t worry that these bankers are wasting time discussing the ball game. More likely they’re doing their jobs and discussing the credit score of one of their loan applicants. 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, especially credit cards, and is becoming more commonly used in mortgage lending (Mester, 2012).

This first section will discuss a credit score in general terms to build your understanding of what is implied by the term ‘credit score’.  I have found that it is very hard to fully grasp the importance of something without having a foundational understanding of what is was I was contemplating.

Where did this Credit Score thing come from?

Credit scores became widely used in the 1980's. Long before credit scores, human judgment was the sole factor in deciding who received credit. Lenders used their past experience at observing consumer credit behavior as the basis for judging new consumers. Not only was this a slow process, but it was also unreliable because of human error. Lenders eventually began to standardize how they made credit decisions by using a point system that scored the different variables on a consumer's credit report. This point system helped to eliminate much of the bias that previously existed; however, it was still tied to intuitive measures of credit worthiness and was not based on actual consumer behavior. Credit granting took a huge leap forward when statistical models were built that considered numerous variables and combinations of variables. These models were built using payment information from thousands of actual consumers, which made scores highly effective in predicting consumer credit behavior. When combined with computer applications, scoring models have made the credit granting process extremely fast, efficient and objective, facilitating commerce and helping consumers quickly get the credit they need.

Credit Score Model

Designers of credit scoring models review a set of consumers - often over a million - who opened loans at the same time, and determine who paid their loan and who did not. The credit profiles of the consumers who defaulted on the loans are examined to identify common variables they exhibited at the time they applied for the loan. The designers then build statistical models that assign weights to each variable, and these variables are combined to create a credit score. Models for specific types of loans, such as auto or home, more closely consider consumer payment statistics related to these loans. Model builders strive to identify the best set of variables from a consumer's past credit history that most effectively predict future credit behavior.

Credit Score Levels

In determining credit scores, lenders place you in a risk category that compares you to a large number of consumers with similar credit histories. This allows lenders to compare "apples to apples," ensuring that your credit behavior is judged in a context that is relevant and fair. For example, consumers with brief credit histories and only a few accounts are not compared to consumers with long-established credit histories. Rather, these consumers will be compared to other consumers who also have brief credit histories. Keep in mind that the attributes of your risk category (i.e. number of accounts, total debt, etc.) may not have the same impact to a credit score for consumers in another risk category.

Contributing Factors

Score factors are the elements from your credit report that drive your credit score. For example, such elements as your total debt, types of accounts, number of late payments and age of accounts are what determine the outcome of your credit score. Score factors can have a positive or negative affect on your credit score. Lenders must provide consumers with the most significant score factors when they are declined credit. With a subscription to ConsumerInfo.com, Inc., an Experian company, ("ConsumerInfo") Triple AdvantageSM, our online credit management service, you can view the negative and positive score factors that drive your PLUS score. In addition, ConsumerInfo.com, Inc., an Experian company, ("ConsumerInfo") Triple AdvantageSM provides score factor advice on how to improve or maintain your credit.

*Loretta Mester is a vice president and economist in the Research Department of the Philadelphia Fed. She is also the head of the department's Banking and Financial Mar- kets section.

Loretta J. Mester*

*www.philly.com. More Advice. May 8, 2008.