Credit Score
How does a creditor decide whether to lend you money for such things as a
new car or a home mortgage? Many creditors use a system called "credit
scoring" to determine whether you are a good credit risk. Based on how well you
score, a creditor may decide to extend credit to you or turn you down. The
following questions and answers may help you understand who gets credit, and
why.
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What is Credit Scoring?
Credit scoring is a system used by some creditors to determine whether to
give you a loan or credit card. The creditor may examine your past credit history
to evaluate how promptly you pay your bills and look at other factors as well,
such as the amount of your income, whether you own a home, and how many
years you have worked at your job. A credit scoring system awards points for
each factor that the creditor considers important. Creditors generally offer credit
to those consumers awarded the most points because those points help predict
who is most likely to pay back the debt.
Why is Credit Scoring Used?
In smaller communities, shopkeepers, bankers, and others who extend
credit often knew by word of mouth who paid their debts and who did not. As
some creditors became larger and as the number of their consumer credit
applications grew, these creditors needed to establish more systematic and
efficient methods for evaluating which consumers were good credit risks. Credit
scoring is one such technique.
Although smaller creditors still may rely on informal credit evaluations, many
large companies now use formal credit scoring systems. Although no system is
perfect, credit scoring systems can be at least as accurate as informal methods
for granting credit -- and often are more so -- because they treat all applicants
objectively.
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How is a Credit Scoring System Developed?
Most credit scoring systems are unique because they are based on a
creditor's individual experiences with customers. To develop a system, a creditor
will select a random sample of its customers and analyze it statistically to identify
which characteristics of those customers could be used to demonstrate
creditworthiness. Then, again using statistical methods, a creditor will weigh
each of these factors based on how well each predicts who would be a good
credit risk
To illustrate how credit scoring works, consider the following example that
uses only three factors to determine whether someone is creditworthy. (Most
systems have 6 to 15 factors.)
Example:
Monthly income Points Awarded
Less than $400 - 0
$400 to $650 - 3
$651 to $800 - 7
$801 to $1,200 - 12
$1,200 and more - 15
Age
21-28 - 11
28-35 - 5
36-48 - 2
48-61 - 12
61 and more - 15
Telephone in home
Yes - 12
No - 0
Some credit scoring systems award fewer points to people in their thirties
and forties, because these individuals often have a relatively high amount of debt
at that stage of their lives. The law permits creditors using properly-designed
scoring systems to award points based on age, but people who are 62 or older
must receive the maximum number of points for this factor.
If, for example, you needed a score of 25 to get credit, you would need to
make sure you had enough income at a certain age (and, perhaps a telephone)
to qualify for credit.
Remember, this example shows very generally how a credit scoring system
works. Most credit scoring systems consider more factors than this example --
sometimes as many as 15 or 20. Usually these factors are obviously related to
your credit worthiness. Sometimes, however, additional factors are included that
may seem unusual. For example, some systems score the age of your car.
While this may seem unrelated to creditworthiness, it is legal to use factors like
these as long as they do not illegally discriminate on race, sex, martial status,
national origin, religion, or age.
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