What is the Purpose of a Credit Score?

Your level of perceived credit risk in the eyes of lenders is reflected by your credit score. A higher number suggests a lower level of credit risk. Your credit score is generated statically from your credit report. However, your credit scores are not stored physically. It will not be found in your credit file as part of your credit history. It is generated only when a lender demands it when they request your credit report.

A fluid number is used to represent your credit score. When there is a change in the circumstances regarding your credit report, your credit score also changes. For instance, there will be fluctuations based on new account or payment updates. In the financial service industry, there are many different credit scores used. Depending on the model of credit scoring employed based on the lender, your score may differ.

In the past, before credit scores became ubiquitous in evaluating creditworthiness, lenders employed less empirical forms of evaluation. Lenders would first look at an applicant’s credit report. Based on the judgment a lender makes, credit would be denied or provided. The lender may look at factors such as whether the applicant had too many late payments or if the applicant already held too much debt. This process was time-consuming and subjective, whereby human judgment became more vulnerable to personal bias and misinterpretations.

However, with the development of credit scores, risk has been more fairly assessed by the lenders. This is because credit scores are objective and consistent, and thus highly beneficial to applicants. Credit scores at their core reflect whether you will be able to repay your liabilities without bias. The score is generated using your present credit status and past credit history.

In order to summarize the credit history of consumers, retail stores, auto dealers, credit card companies, banks and most other lenders make use of credit scores. It saves time in having to manually review the credit report of the applicant, thereby streaming the decision-making process. A credit score is the most prominent sign of one’s basic creditworthiness, though many additional factors are used in determining risk, such as an applicant’s income versus the size of the loan, among other factors.

Depending on the score being used, the information that impacts a credit score varies. Usually, elements in your credit report directly affect your credit scores. These elements include: recent inquiries; total debt burden; the type, number and duration of accounts; as well as the number and nature of late payments.

Under the Equal Credit Opportunity Act, scores formulated by companies like TransUnion must not incorporate demographic data precluded by the Consumer Credit Protection Act, including racial, religious, ethnic or gender identifying distinctions. Individual lenders may use scores which include elements like occupation, income and type of accommodation in deciding their own custom score of credit.

Background of Credit Scores

Credit scores began to gain popularity in 1980s. In determining whether or not to provide credit, human judgment had been the sole factor, as mentioned previously. In order to judge the new consumers, lenders used their past experience at observing consumer credit behavior. It was an unreliable as well as a slow process, featuring many errors and inconsistencies.

Hence, lenders started to use the point system, whereby consumers were given scores according to their credit report. Many of the previous existing inefficiencies were solved by this point system. Still, it was not used as the best method to assess creditworthiness. Eventually, consumer credit behavior could be predicted using credit scores, and it began to be instituted across the board. The process of assigning credit score became very easy when it was combined with computer applications. Ultimately, the process became objective, effective and fast, whereby consumers received credit decisions expediently.

Risk Profile

When determining credit scores, lenders evaluate risk categories. They compare large numbers of consumers with similar credit scores and decide whether to grant credit or deny it. Hence, lenders are able to compare theoretically consistent factors and criteria, whereby your credit behavior is judged in a context that is fair and relevant. For instance, consumers with established credit histories will not be compared to consumers with brief credit history and only a few accounts. This ensures that you receive the best change of securing the credit you need to bolster your life.

 

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