The Individual or Consumer Credit Score
By Wayne M. Crane, Summit Alternative Investments
The individual or consumer credit score, also known as a risk score, is a number that incorporates information contained in credit bureau reports or other sources of information, offers some measure of the creditworthiness of individual consumers and allows an easy way to classify credit applicants based on their probable risk of default.
Credit scores can be computed in many different ways, and thus, many different scores exist. However, all of these scores are based on statistics and data analysis of credit bureau reports. Their reliability in measuring actual creditworthiness is tested by studies that measure the actual future behavior of people, from a sample that is representative of the general population, with the same credit score.
The goal of any credit score model is to be able to identify as many people as possible who are actually good credit risks, while also identifying the bad risks. If the credit scoring model is too stringent, it may eliminate many people who are actually good credit risks. This results in decreased profits to lenders because they are eliminating those potential customers who failed to pass the minimum score set by the lender. On the other hand, a relaxed scoring model may give h
igh scores to people who are actually poor credit risks, which will decrease profits for lenders. With a relaxed model, they will lend money to many people who may not pay back the loan. Thus, the value of credit scores to lenders, and why they prefer one score over another, is the predictive value of the score in assessing the creditworthiness of people—to know which people will likely pay back their loan and which are significant credit risks. In other words, for instance, statistics may indicate that 6% of the people with a particular credit score will default on their loan at some time during the life of the loan, but only 2% of the people with a higher score will default. This allows lenders to measure risk accurately, which, in turn, allows them to maximize their profits.
When providing indirect financing, many lenders (Summit and its affiliates included) will use a combination of the purchase price of a loan contract and the annual percentage rate charged to the consumer to mitigate risk. In other words, a loan contract may be purchased from a merchant at ninety cents on the dollar and/or interest rates may vary based on the credit score of the applicant. Indirect financing is when borrowers utilize funds from the lender through indirect means, such as through a financial intermediary, such as an auto dealer or home improvement merchant. This is different from direct financing, in which there is a direct connection between the lender and the borrower.
Thus, lenders use credit scores to qualify loan applicants and to determine the appropriate interest rate to charge. A higher creditscore indicates a lesser credit risk, and therefore lenders will be willing to charge a smaller interest rate. A lower score indicates a greater credit risk, and thus, lenders will charge a higher interest rate on a loan to compensate for taking a greater risk, or alternatively, may need to purchase the loan at a discount.
As a number, scoring allows companies to set standards, such as requiring a minimum credit score to be considered for a loan. Summit and its affiliates utilize individual credit scores as a starting point. It is only “chapter one” of the story so to speak. Summit also utilizes additional information that is included in the body of a credit report, thereby providing a much higher level of analysis so as to approve as many credit applications as possible. Variables such as how much an individual has consumed of their revolving credit available to them is another predictor of default. The more revolving credit capacity available, the lower the risk factor of default. Summit employs a number of additional factors in determining credit risk including factors relating to historical default experience in Summit’s previous consumer portfolio investments.
Without a credit score as an initial starting point, each credit report would have to be examined in detail, consuming time and resulting in different evaluations of credit based on the personal judgment of the underwriter. Because the credit score is updated as new information is added to the credit report, recent items have more significance than older items. Thus, payment problems in the past become less important if current payments are timely.
Credit scores can differ for the same individual because each of the three major credit bureau reports have slightly different models. Credit scores from the different reporting bureaus use different algorithms in computing the scores. Different scoring algorithms are available that may better predict creditworthiness for specific types of applications as well, for example for primary mortgage lending, or retail consumer product lending. To remain consistent a typical strategy for lenders is to utilize one credit score from one of the bureaus, rather than all three of the reporting entities.
- 30 Jul, 2015
- Josh Smith