What is credit scoring? About types, model and method

In the complex world of finance, the concept of credit scoring plays a pivotal role in determining an individual's or a business's creditworthiness. As financial institutions increasingly rely on data-driven assessments to make lending decisions, understanding the nuances of credit scoring becomes crucial for both borrowers and lenders alike.

What is a credit scoring?

Credit scoring is a systematic and statistical method used by financial institutions to assess the creditworthiness of individuals or businesses seeking financial products, such as loans or credit cards. It involves the evaluation of various factors, including but not limited to, an individual's or a company's credit history, payment behavior, outstanding debts, and financial stability. The goal of credit scoring is to quantify the level of risk associated with extending credit to a particular borrower.

What is a credit scoring?

This numerical representation, often in the form of a credit score, helps lenders make informed decisions about approving or denying credit applications, as well as determining interest rates and credit limits. A higher credit score typically indicates a lower credit risk, making it more likely for an applicant to secure favorable terms and conditions. Conversely, a lower credit score may result in higher interest rates or even a denial of credit. Credit scoring plays a crucial role in modern financial systems, enabling efficient and objective evaluation of credit applicants to promote responsible lending and mitigate financial risks for both borrowers and lenders.

Credit scoring models

Credit scoring models play a crucial role in assessing the creditworthiness of individuals and businesses. These models leverage statistical algorithms and historical credit data to evaluate the likelihood of a borrower defaulting on a loan or credit obligation. The primary objective is to provide lenders with a quantitative measure that helps them make informed decisions about extending credit. Traditional credit scoring models consider factors such as credit history, outstanding debts, payment history, and the length of credit history. However, with advancements in technology and the availability of big data, newer models may also incorporate alternative data sources and machine learning techniques to enhance accuracy. The continuous evolution of credit scoring models reflects the dynamic nature of the financial landscape, enabling more precise risk assessment and informed lending practices.

Credit scoring model. How is it calculated?

Banks usually grant loans based on a credit scoring model that combines qualitative and quantitative analysis. Credit scoring is based on statistical methods, thanks to which it is possible to predict the probability of a certain event occurring in the future - in this case a loan default.

The scoring process uses information about the customer collected at the application stage - mainly data characterizing the customer, but also information about their past behavior. Each credit institution considers a different set of features and assigns different point values to them. For example, a highly educated person will usually score higher than a college dropout, but the exact point value and its impact on the final score may vary from bank to bank. The sum of points from particular characteristics is usually the final score.

Credit scoring model. How is it calculated?

The FICO score, a widely used credit scoring system in the United States, is crucial for determining an individual's creditworthiness. This three-digit numerical representation, ranging from 300 to 850, plays a pivotal role in influencing lending decisions made by financial institutions. The breakdown of FICO scores into specific ranges provides a comprehensive overview of a person's credit health. Generally, a score above 800 is considered excellent, indicating a low credit risk, while scores between 740 and 799 are deemed very good. Good scores fall in the range of 670 to 739, suggesting a moderate credit risk. Fair scores, ranging from 580 to 669, may encounter challenges in obtaining favorable terms, and scores below 580 are considered poor, reflecting a higher credit risk. Understanding this division of FICO scores is essential for individuals seeking loans, mortgages, or credit cards, as it directly impacts their ability to secure favorable financial arrangements. Regularly monitoring and managing one's credit profile is key to achieving and maintaining a desirable FICO score.

Read about: How credit scores can improve risk assessment?

VintageStore: modern competitor credit scoring

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Credit scroing method

Determining the level of customer reliability with regard to the timely loan repayment is one of the key elements of credit risk assessment. This is done on the basis of a credit history analysis and scoring, based on the customer's characteristics. Information on how the customer has repaid, and continues to repay, their dues is often provided by credit bureaus. While the customer assessment itself is based on credit scoring models.

Credit scroing method

The use of scoring models in credit processes is very popular due to its numerous benefits:

  • shorter processing time of applications, which also leads to lower costs
  • objective assessment of credit risk
  • improved employee productivity
  • possibility of using appropriate financial collateral
  • monitoring the credit portfolio for bad credits
  • better forecasts and credit strategies

What influences credit scoring?

Many factors are taken into account in the process of granting a loan. These include the characteristics of the borrower (who they are), their economic situation, the amount of the loan applied for, its purpose (i.e. what is to be financed by the loan) and the type of collateral. The variety of these factors means that the risk is estimated using elements of quantitative and qualitative analysis.

The quantitative analysis includes, first of all, an assessment of the financial standing of the customer based on their income and monthly expenses. It may also include cash flow analysis of the customer's accounts and credit history. While the qualitative assessment takes into account, among others, marital status, education or employment form - for natural persons, and for enterprises - legal form, industry in which they operate or the way of keeping accounts.

Equally important are past customer behaviors that adversely affects credit scoring:

  • late payment of installments and other liabilities,
  • exceeding credit card limits,
  • large number of commitments entered into,
  • no credit history of any kind.

How to check your credit score?

Checking your credit score is a crucial step in managing your financial well-being. Your credit score is a numerical representation of your creditworthiness, and it plays a significant role in determining your eligibility for loans, credit cards, and other financial products. To check your credit score, you can start by obtaining a free credit report from major credit bureaus such as Equifax, Experian, or TransUnion. These reports typically include your credit score along with detailed information about your credit history, including any outstanding debts, payment history, and accounts in your name.

How to check your credit score?

Another way to monitor your credit score is through various online platforms that offer free credit score checks. Many financial institutions and credit card companies also provide regular updates on your credit score as part of their services. Keep in mind that different credit scoring models may yield slightly different scores, so it's essential to understand the specific scoring system used.

Regularly reviewing your credit score allows you to identify any discrepancies, errors, or fraudulent activities that may impact your financial standing. Additionally, a good credit score opens doors to favorable interest rates and better loan terms. By staying informed about your credit score, you empower yourself to make informed financial decisions and take proactive steps to improve or maintain a healthy credit profile.

What are the types of credit scoring?

Scoring models can be classified according to different criteria. Thus, we can talk about a scoring of individuals or companies (division based on the assessed entity) or credit card, cash or mortgage scoring (depending on the type of product applied for by the client). Taking into account who created and managed the scoring model, we can talk about internal scoring (prepared by banks for their own needs) or external scoring (created and made available by specialized institutions, e.g. credit information offices).

There is a very clear dividing line between application and behavioral scoring. The first one is designed to evaluate new customers on the basis of data provided by the customer in the credit application. Behavioral scoring, on the other hand, is determined on the basis of the history of the customer's behavior concerning the service of financial products. Therefore, it is calculated for regular customers, mainly in order to resell new products or change the terms and conditions of existing products (e.g. increase the credit card limit).

For the most part, the goal of the scoring models is to determine the risk of debt default. However, more and more emphasis has been placed recently on using this method for other purposes:

  • profit maximization (what credit terms should be offered to the customer to be accepted, i.e. risk-based pricing)
  • increasing the effectiveness of marketing campaigns by investigating whether the customer will be interested in a given product,
  • fraud scoring,
  • attrition scoring,
  • improving debt management by determining whether the customer will be able to repay the loan in the event of financial problems.

Regardless of the type, the scoring models enable an objective assessment of credit risk, which is a key element of the credit granting process. In order to make the credit calculation as accurate, transparent and low-risk as possible, banks increasingly automate it and use ready-made systems that allow for performing a credit assessment model in a point system. The use of such tools reduces the probability of granting doubtful loans and allows for accelerating the entire credit process while reducing the risk of human error.

Individual customer scoring

The risk assessment of natural persons is based on their personal characteristics. The most commonly used are: age, marital status, education, number of dependents, seniority, form of employment, occupation, etc. The risk assessment of natural persons is based on their personal characteristics. Financial characteristics also play a very important role, such as monthly income, possible additional income or information about expenses (repayment of other loans, living costs, bills paid, etc.). If possible, data on the financial history of the customer are also taken into account, such as the number of previous commitments made and the history of their repayment or information about possible overdrafts.

Depending on the type of credit applied for, the list of characteristics to be taken into account in the risk assessment may vary. The scoring model for a mortgage loan is usually more comprehensive than that for a credit card. When buying a house on a loan, the scoring also includes a number of information about the property itself (including its value, LTV level, etc.). It also puts more emphasis on the income data.

Enterprise Scoring (SME)

In the case of small and medium-sized enterprises, the risk of bankruptcy and insolvency is examined by assigning points. Their capital, debt and development strategy are taken into account. In the case of enterprises, the credit calculation is made on the basis of: the characteristics of the industry, the characteristics of the company, its previous financial results. Credit risk analysis is also performed taking into account the company's structure, source of financing, competition, and even the qualifications of employees, mainly those at high levels, are examined. The credit assessment model in the case of a company also takes into account the financial condition of the company, its planned projects, liquidity, financial liabilities and industry risk assessment.

In the case of the smallest companies, however, very often, in addition to taking into account the parameters characterizing the company, the owner of the examined company is also the owner. It turns out that the profile of the owner and their personal credit history is more important than the numbers describing their business. This is particularly often used in the case of the smallest entities operating on the market for a short period of time.

What is a good credit scoring?

Having a good credit score is paramount for individuals seeking access to various financial products and services. A good credit score typically reflects a borrower's creditworthiness and responsible financial behavior. While scoring models may vary between credit bureaus and financial institutions, a credit score generally falls within a specific range in the FICO scoring model. Achieving a good credit score opens up opportunities for favorable terms on loans, mortgages, credit cards, and insurance premiums, allowing individuals to access higher credit limits, lower interest rates, and better terms overall.

What is a good credit scoring?

Maintaining a good credit score requires consistent financial discipline and responsible credit management. Factors that contribute to a good credit score include a history of timely bill payments, low credit utilization ratio (the amount of credit used compared to the total available credit), diverse credit mix (having a combination of installment loans and revolving credit accounts), and a longer credit history. Additionally, avoiding excessive credit inquiries and derogatory marks such as bankruptcies, foreclosures, or collections accounts is essential for preserving a good credit score. By demonstrating reliability in managing credit and debts, individuals can enjoy the benefits of a good credit score and enhance their financial stability and opportunities in the long term.

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