Technological advancement has given modern financial lenders an unparalled capacity to reduce lending risk, now that lenders can utilize more customer data than ever to make informed considerate lending decisions.
Lenders stay in business when borrowers pay back loans. Some borrowers consistently make prompt payments while others are slow to repay and still others default – meaning they do not pay back the money they borrowed. So how do lenders distinguish between good borrowers and risky ones?
They rely on various proprietary credit scoring systems that use past borrower repayment history and other factors to predict the likelihood of future repayment. Credit scoring is an integral part of today’s financial landscape, and credit scoring techniques are used in various industries and organizational departments.
With software tools available to today’s lenders, there has never been a better time to learn more about how to optimize credit scoring, how to minimize risk, and what a streamlined, flexible and powerful credit risk mitigation strategy can do for an organization.
Many financial and retail organizations tell their customers they can “buy now and pay later” when trying to help them increase their customer base. However, both parties need to know the risks when taken such a credit decision.
For both the lender and the customer, it’s paramount that lenders can be confident that customers will honour their credit obligations and pay the lender what they owe by the end of a loan term. Additionally, lenders must be able to assess each of its customers’ default risk so they can decide who they should offer loans to, and who they shouldn’t.
Consequently, in the complex world of finance, the concept of credit scoring plays a pivotal role in determining an individual’s or business’s creditworthiness. Understanding the nuances of credit scoring becomes crucial for both borrowers and lenders alike.
Fortunately, the system has just been launched in Ghana known as MYCREDIT SCORE. Therefore, having enough knowledge about how it works and the enormous benefits been enjoyed by countries that have implemented it, will greatly enable users to appreciate it.
Evolution of credit score
Developed in the late 1950s, the first credit scores – FICO (First Isaac Corporation) scores, were created to build a computerized objective measure to help lenders make lending decisions. Before then, bankers relied on commercial credit reporting, the same system merchants used to evaluate the creditworthiness of potential customers based on relationships and subjective evaluation.
The FICO credit scoring system was enhanced over the 1960s and 70s and lenders grew to trust computerized credit evaluation systems. Credit scores really began to exert an influence on American borrowers beginning in the 1980s as FICO become widely used. The major goal of the credit score is to expand the pool of potential borrowers while minimizing the overall default rate of the pool. In this way, lenders can minimize the number of loans they make.
Still credit scores are imperfect predictors, likely because most credit models assume that consumers will continue to act in the same way in the future as they have in the past. In addition, some believe that various risk factors make credit scores imperfect.
Credit modellers, however, continue to make progress by making continuous technological innovations. Even FinTech lenders who strive to go beyond traditional credit models heavily rely on credit scores to set their interest rates.
What is credit scoring system?
A credit scoring system evaluates an individual’s or entity’s creditworthiness based on various financial factors and historical data. Using a numerical score, aids lenders in assessing the risk associated with extending credit and facilitating informed lending decisions. The system streamlines the credit evaluation process, providing a standardized and objective measure of credit risk.
In other words, credit scoring is a common terminology for statiscal method used by lenders to assess the creditworthiness of individual or entities, based on their credit history. This process involves analyzing various factors, including payment history, amount owed, length of credit history, new credit accounts, and types of credit used (Source: LinkedIn).
The information is then distilled into a numerical score. The range of scores could differ from one provider to another (eg. from 0 to 100 for one provider and 300 to 850 for another), depending on how the models are calibrated. Typically, higher scores indicate better creditworthiness.
Below are examples of countries implementing credit scoring system:-
Germany
Australia
Canada
Spain
China
Japan
United Kingdom
France
Netherlands
South Africa
Factors that influence 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 (ie. what is to be financed by the loan) and the type of collateral. The variety of these factors mean 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.
The qualitative assessment on the other hand, 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 behaviours 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.
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 eg. Credit Information Office).
There is a very clear dividing line between application and behavioural scoring. The first one is designed to evaluate new customers on the basis of data provided by the customer in the credit application.
Behavioural scoring, on the other hand, is determined on the basis of the history of the customer’s behaviour concerning services 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 (eg. 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 detailed below:-
Profit maximization (what credit terms should be offered to the customer to be accepted, ie. 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.
How does credit scoring system works
A credit score can significantly affect your financial life. It plays a key role in a lender’s decision to offer you credit. Lenders are more likely to approve you for loans when you have a higher credit score, and are more likely to decline your loan applications when you have lower scores. You can also get better interest rates when you have a higher credit score, which can save your money in the long-term.
Conversely, a credit score of 700 or higher is generally viewed positively by lenders, and may result in a lower interest rate. Scores greater than 800 are considered excellent. Every creditor defines its own ranges for credit scores and its own criteria for lending. Here are the general ranges for how credit scores are categorized:-
Excellent: 800 – 850
Very Good: 740 – 799
Good: 670 – 739
Fair: 580 – 669
Poor: 300 – 579
How it is calculated
Credit scores are calculated based on a record of one’s previous interactions with lenders – a document called credit report. Here are the five (5) main factors that FICO, the leading credit score provider, generally evaluates when calculating score. They include:-
PAYMENT HISTORY – (35%)
Before lenders extend credit to you, they want to know your payment history. Your payment history includes whether you have paid your bills on time. It takes into account how many late payments you have had, and how late they were. Always make at least the minimum payment by the due date.
AMOUNT OWED – (30%)
Amount owed is the percentage of credit you have used compared to the credit utilization. High balances can hurt your score. Lenders prefer that you use less than 30% of your available credit. You may be able to check what percent you are using on your account page on your bank’s website.
LENGTH OF CREDIT – (15%)
Your score considers how long you have been using your credit accounts. Generally, longer credit histories are considered less risky, as there is more data to determine payment history.
CREDIT MIX – (10% )
This data point looks at the types of credit accounts you have. It’s considered financially healthy to successfully manage multiple account types – such as credit cards, mortgages, and student loans – but it’s not necessary to apply for different types of accounts you don’t need.
CREDIT INQUIRIES – (10%)
Lenders see you as a bigger risk if you apply for or open, several new credit accounts in a short time. Too many recent applications for credit can negatively affect your credit score.
The weight assigned to each category can vary depending on your individual circumstances. If you are just starting to establish credit, the factors used to calculate your score may be different from someone who has a longer credit history.
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 behaviour. 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 favourable terms on loans, mortgage, credit cards and insurance premium, allowing individuals to access higher credit limits, lower interest rates and better terms overall.
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).
A longer credit history.
Avoiding excessive credit inquiries and derogatory marks such as bankruptcies, foreclosures or collections accounts.
All the above-mentioned requirements are essential for preserving a good credit score and enhancing one’s financial stability and opportunities in the long term. That dream business venture which requires a loan, the destination wedding, student loans, and various expenses that might crop up on you unnoticed, can be dealt with through credit purchases.
Having a good credit score will help you get the grants without much of a hassle since you will be assessed to be of lower risk. More importantly, you will be asked to pay off your debt a lower interest rates.
How to improve your credit score
Improving your credit score can have a range of benefits from accessing better deals to increasing your chances of mortgage approval. When information is updated on a borrower’s credit report, the credit score changes and can rise or fall based on new information. Here are some ways that you can improve your credit.
Stay within your credit limits and make sure you pay bills on time. Late payments will be visible on your credit file for at least six (6) years and can affect your ability to borrow.
Don’t apply for too much credit in a short space of time. Use an eligibility checker before you apply for a credit card as this avoids leaving a hard check on your life.
Check your credit score regularly to make sure the details are correct and up to date. It is important to make sure the credit information held on you is correct and as healthy as it can be.
Keep an open line of communication and make repayment arrangements when experiencing financial difficulty with the creditor.
Limiting the number of credit card applications is a sure-shot way of never extending your credit amount, not going over the top while spending is the wisest of decisions one can take while trying to improve credit score.
Don’t close a credit card account. If you are not using a certain credit card, it is best to stop using it instead of closing the account. Depending on the age and credit limit of a card, it can hurt your credit score if you close the account.
If you are having trouble securing credit, it is possible to improve your credit rating over time by taking the above-mentioned steps to boost your score.
How to check your credit score
Just like there are many different types of credit scores available, there are many different ways to check your credit score. There are a number of free resources, but some organizations will charge you. It is perfectly safe to check your credit score anytime you want – and it can be smart to check it regularly, especially, before making a big financial move, like buying a car or a home.
USE A CREDIT SCORE SERVICE OR SCORING SITE
To check your credit score early at no cost, you can use credit score websites. By signing up and creating an account, you can get updates about your credit scores and credit activity such as a drop or increase in your score or the opening or closing of accounts.
REQUEST YOUR SCORES FROM THE MAJOR CREDIT BUREAUS
You can also access your credit score through one of the major credit bureaus. Each credit bureau has various credit monitoring products, some of which are at no cost and some of which you have to pay for.
CHECK WITH YOUR BANK
Some financial institutions offer credit services that allow you to keep tabs on your credit score and any month–to–month fluctuations.
CHECK WITH YOUR CREDIT CARD ISSUER
As credit card competition heats up, many companies are adding new parks for users and that includes access to your credit scores
Benefits of credit scoring system
Consumers, purchasers and business ventures alike are highly dependent on credit in the present day. The entire system of the availability of credit, the time period of the acceptance of an offer is dependent on your credit score.
Credit score is not merely restricted to those who seek credit but can also present a more responsible image of you in the eyes of prospective employers. Below are the immense benefits to be derived from credit scoring system:-
ACCESS TO CREDIT
One of the primary benefits of credit scoring is its role of facilitating access to credit. By evaluating borrowers’ creditworthiness, lenders can make informed decisions about extending credit, enabling individuals to make significant purchases such as homes or vehicles that they might not be able to afford outright.
IMPROVED FINANCIAL DISCIPLINE
Credit scoring encourages responsible financial behaviour by incentivizing individuals to maintain good credit habits. It prompts individuals to manage their finances prudently and avoid behaviours that could negatively impact their creditworthiness. For instance, not paying one’s credit card at a bank will impact his housing loan application at another bank.
REDUCE THE COST AND TIME OF CREDIT EVALUATION AND APPROVAL
By using standardized and automated procedures, credit scoring can eliminate the need for manual review and human judgement, which can be costly, time-consuming and prone to errors or biases. Credit scoring can also speed up loan processing and disbursement, which can improve customer satisfaction and loyalty.
FINANCIAL STABILITY AND ENHANCED RISK MANAGEMENT
A well-functioning credit scoring system promotes financial stability by enabling lenders to make informed lending decisions based on borrower’s creditworthiness. By having a quantitative tool to assess credit risk, lenders can mitigate the likelihood of defaults, delinquencies or fraud, thereby reducing systematic risks within the financial systems. This fosters confidence among investors, lenders and consumers, contributing to a stable and resilient financial industry.
IMPROVES CONSISTENCY AND ACCURACY OF CREDIT DECISIONS
By using objective and quantifiable criteria, credit scoring can ensure that all applicants are treated fairly and equally, regardless of their personal characteristics, such as age, gender, race, or religion. Credit score can also reduce the variability and uncertainty of credit decisions, which can enhance the reliability and predictability of the credit portfolio.
IMPACT ON ECONOMIC GROWTH
A strong credit-scoring infrastructure is integral to fostering economic growth and development. By facilitating access to credit for businesses and individuals, credit scoring promotes investments, entrepreneurship and innovation, driving economic expansion and job creation, leading to sustained growth and prosperity.
LIMITATIONS OF CREDIT SCORING SYSTEM
It is imperative to note that, despite the above-mentioned benefits, the likely limitations should not be ignored. These include:-
QUALITY AND AVAILABILITY OF DATA
Credit scoring can be affected by the quality and availability of data. Credit scoring relies on accurate and comprehensive data to build and validate the scoring models, which can be challenging to obtain, especially in developing countries or emerging markets, where the credit information systems are not well-developed or regulated. Errors such as incorrect personal information, outdated account status or fraudulent activities can adversely affect credit scores.
Credit scoring can also be influenced by the timelines and relevance of data, which can change over time due to economic, social or environmental factors, such as inflation, recession or natural disasters.
COMPLEX AND SOPHISTICATED MATHEMATICAL STATISTICAL TECHNIQUES
Credit scoring involves complex and sophisticated techniques, which can be difficult to understand, interpret, and explain, especially for non-technical users, such as customers, regulators, or auditors. Credit scoring can also constrained by the assumptions and parameters of the models, which can be inaccurate, outdated, or inappropriate, especially for new or innovative products, markets, or segments such as microfinance, peer-to-peer lending or online lending.
IMPACT OF NEGATIVE INFORMATION
Late payments, defaults, bankruptcies and other adverse events can significantly impact credit scores and may linger on credit reports for some years. While credit scoring algorithms consider various factors, negative information can outweigh positive aspects, making it challenging for individuals with blemished credit histories to secure favourable loan terms.
Conclusion
For many individuals, these new avenues of financing provide the tools to overcome systemic barriers that have long constrained their financial aspirations. Traditional credit assessments often rely on rigid metrics that fail to capture the full picture of a person’s financial behaviour and potential.
Credit scoring system solutions utilize a range of data from payment histories to other relevant forms of data offering a more nuanced understanding of an individual’s creditworthiness. This shift has profound implications for economic empowerment. By recognizing the value of digital footprints, credit institutions are not only enabling greater access to funds but also instilling a sense of urgency in those who have been overlooked by traditional systems.
source: Business and Financial Times
