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Credit scores: what they are

July 8, 2011

I’ve decided that it’s time to write about credit scores.  This week’s post will discuss what credit scores are; next week I’ll discuss what they aren’t.

Most readers will may already know that “credit scores” are numbers ranging from 300-850 that are intended to estimate the risk that a particular consumer will fail to make payments on existing debt at some point in the next two years, to the point that the consumer has failed to make a payment for 90 days.  If a consumer is likely to become 90 days late on existing debt, he or she will have a lower score; if a consumer is unlikely to become late, he or she will have a higher score.  Consumers with low credit scores may find that some lenders won’t lend to them at all, or that lenders will charge a high interest rate to compensate for the perceived risk of late payments or default.

The first credit scores were developed by Fair Issac & Company and are therefore called “FICO” scores.  Creating credit scores is an art as well as a science:  FICO, or anyone else who creates credit scores, must devise a series of algorithms that take the raw data on a consumer’s credit report (i.e., the fact that consumer A has a credit card with Bank B that has a credit limit of C, an existing debt of D, and has (or hasn’t) made timely payments in months X, Y, and Z) and translate it into a number between 300-850 that does the job it’s supposed to do (i.e., predicts whether consumer A will become late in making payments on that credit card or on other debt).

Back in the mists of time, consumers who wanted a loan would meet with a bank officer who would read through their credit report and then, after assessing not just the report but also the consumer (does she seem honest?  does he have a firm handshake?  etc.) decide whether to extend a loan and on what terms.  This system had obvious problems.  For starters, different bank officers would read credit reports and people differently, so that the same person could meet with two different officers at the same bank and get different decisions on whether and how a loan would be made.  The fact that the bank officers assessed borrowers as individuals had a nice homey quality, but it also opened banks up to allegations of racism and sexism.  In addition, bank officers were expensive:  their salaries and benefits cut into a bank’s own profits.

So, for a while now banks have been using credit scores to make lending decisions instead of bank officers.  Just about every bank uses a FICO score, in which Fair Issac & Co. scans raw data on a consumer’s Experian, Equifax, or Trans Union credit report, and then uses FICO algorithms to translate that data into a number from 300-850.  The bank then uses its own algorithms to match the credit score, the proposed new debt, and the consumer’s income (income doesn’t appear on credit reports and therefore isn’t considered when creating credit scores!) and decide whether and on what terms to lend.  Banks like this system is cheaper (it involves computers and not people); more predictable (same); and less open to accusations of racism and sexism than the old personal approach to lending.

That’s what credit scores are.  Next week I’ll discuss what they aren’t.

Categories: Uncategorized
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