Credit Scoring Definition

What is Credit Rating?

Credit score is a statistical analysis performed by lenders and financial institutions to determine the solvency a person or a small owner-operated business. Credit scoring is used by lenders to help decide whether to extend or deny credit. A credit score can impact many financial transactions, including mortgages, auto loans, credit cards, and private loans.

Key points to remember

  • Credit scores determine a person’s ability to borrow money for mortgages, auto loans, and even private loans for college.
  • Both VantageScore and FICO are popular credit scoring models.
  • Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment.
  • Credit ratings apply to businesses and governments, while credit rating applies to individuals and small owner-operated businesses.

How the credit score works

Credit scoring models may differ slightly in how they rate credit. Fair Isaac Corporation credit reporting system, known as FICO scoreis the most widely used credit reporting system in the financial industry, used by over 90% of major lenders. However, another popular credit scoring model is VantageScore, which was created by the three major credit reporting agencies: TransUnion, Experian and Equifax.

A person’s credit score is a number between 300 and 850, with 850 being the highest possible score. Small business credit scores, like the FICO Small Business Scoring Service (SBSS), range from zero to 300.

An individual’s credit score is influenced by five categories:

  • Payment history (35%)
  • Amounts due (30%)
  • Length of credit history (15%)
  • New credit (10%)
  • Composition of credit (10%)

A small business’s credit score is based on information in its credit report, including:

  • Company information (including number of employees, sales, ownership and subsidiaries)
  • Historical trade data
  • Company registration details
  • Summary of Government Activities
  • Company operational data
  • Classification and industry data
  • Public filings (liens, judgments and Uniform Commercial Code [UCC] deposits)
  • History of payments and receipts
  • Reports on the number of accounts and details

Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment. In general, the higher the credit score, the better the rate offered by the financial institution.

The higher your credit score, the better your interest rate will be.

Credit Score vs Credit Rating

A similar design, credit rating, not to be confused with credit rating. Credit ratings apply to corporate, sovereign, sub-sovereign and securities of these entities, as well as asset-backed securities, and are rated on an alphabetical scale. Credit scoring models paint a picture of an individual’s relationship with credit, and scores vary (although they don’t usually change drastically) between the three major credit bureaus. A credit score determines both the interest rate for repayment and whether the borrower will be approved for a loan or debt issuance.

Credit rating limits

Although credit rating classifies a borrower’s credit risk, it does not provide an estimate of a borrower’s probability of default. It simply rates a borrower’s degree of risk from highest to lowest. Thus, credit scoring suffers from its inability to determine whether Borrower A is twice as risky as Borrower B.

Another interesting limitation to credit rating is its inability to explicitly account for current economic conditions. If Borrower A has a credit score of 800, for example, and the economy goes into a recession, then Borrower A’s credit score will not adjust unless the behavior or financial situation of Borrower A does not change.

However, FICO attempted to address this drawback by instituting the FICO Resilience Index in April 2020. According to Experian, it “is designed to assess consumers with respect to their resilience or susceptibility to an economic downturn and provides insight of consumers most likely to default during times of economic stress.It can be used by lenders as another input into credit decisions and account strategies throughout the credit life cycle and can be provided with a credit report, as well as the FICO score.

More advanced credit risk modeling methods, including structural models and reduced-form models, are used to assess the probability of default. Technological advancements, such as machine learning and other analytical-friendly computer languages, continue to scientifically refine the accuracy of credit risk modeling.