Scoring for Credit

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.

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.

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.