Credit Scoring Models 101: Types and Examples for a Stronger Financial Future

Introduction: What is A Credit Scoring Model?

Credit scoring models are statistical tools that evaluate creditworthiness and determine the likelihood of default on credit obligations. These models are used by credit bureaus and lenders to assess the risk of lending money or extending credit to individuals or businesses.

The credit scoring model evaluates various factors, including payment history, credit utilization, length of credit history, types of credit accounts, and recent credit inquiries. Each factor is assigned a weight, and the model’s formula calculates a credit score based on the evaluation.

A credit score typically ranges from 300 to 850, with a higher score indicating a lower risk of default. Lenders use credit scores to make decisions about loan terms, including interest rates, repayment periods, and loan amounts. A good credit score can result in favorable loan terms, while a poor score can lead to higher interest rates and less favorable terms.

Why Is the Credit Risk Scoring Model Important?

The credit risk scoring model provides a standardized and objective way for lenders to assess the creditworthiness of individuals and businesses. By using a credit scoring model, lenders can evaluate the risk of lending money or extending credit to a borrower, allowing them to make informed decisions about loan terms and interest rates.

Without a credit risk scoring model, lenders would have to rely on subjective judgments and personal opinions when evaluating a borrower’s creditworthiness. This could result in inconsistencies and potentially discriminatory lending practices. A standardized credit scoring model ensures that all borrowers are evaluated based on the same criteria, creating a fair and transparent lending process.

Discovering the Different Types of Credit Scoring Models Used in Finance

There are various types of credit scoring models used in finance, each with its own unique methodology and criteria. Understanding the different types of credit scoring models can help individuals and businesses make informed decisions about credit and loans.

1. FICO Score:

The FICO score is the most commonly used credit scoring model in the United States. It uses a range of factors to calculate a credit score, including payment history, credit utilization, length of credit history, types of credit accounts, and recent credit inquiries. FICO scores range from 300 to 850, with higher scores indicating a lower risk of default.

Here is a look at each category and the weight it carries in determining the credit score:

• Payment history (35%): This factor evaluates how consistently a borrower has made payments on their debts. A borrower who has always made on-time payments will receive a higher score than one who has missed payments.

• Credit utilization (30%): This factor evaluates the percentage of available credit that’s being used. A borrower who uses less than 30% of their available credit will receive a higher score than one who uses more.

• Length of credit history (15%): This factor evaluates how long a borrower has had credit accounts open. A borrower who has a long history of credit accounts in good standing will receive a higher score than one who is new to credit.

• Types of credit accounts (10%): This factor evaluates the types of credit accounts a borrower has, such as credit cards, loans, and mortgages. A borrower who has a diverse mix of credit accounts will receive a higher score than one who only has one type of account.

• Recent credit inquiries (10%): This factor evaluates how frequently a borrower has applied for credit. A borrower who has made few recent credit inquiries will receive a higher score than one who has made many.

FICO scores are used by a wide variety of lenders, including banks, credit card companies, and mortgage lenders. A good FICO score can result in lower interest rates and better loan terms, while a poor score can lead to higher interest rates and less favorable terms.

2. VantageScore:

The VantageScore is a newer credit scoring model that was developed jointly by the three major credit bureaus. It also uses a range of factors to calculate a credit score, but weighs them differently than the FICO score. VantageScores range from 300 to 850, with higher scores indicating a lower risk of default.

VantageScore 4.0, the latest version of the model, uses six factors to calculate a credit score: payment history, age and type of credit, percentage of credit limit used, total balances and debt, recent credit behavior and inquiries, and available credit. The VantageScore model puts less emphasis on payment history and more emphasis on credit utilization than the FICO model.Here is a look at each category and the weight it carries in determining the credit score:

• Payment history (40%): This factor evaluates how consistently a borrower has made payments on their debts, similar to the FICO score.

• Age and type of credit (21%): This factor evaluates the borrower’s credit history, including the age of their oldest and newest credit accounts and the mix of credit types.

• Percentage of credit limit used (20%): This factor evaluates the borrower’s credit utilization, similar to the FICO score.

• Total balances and debt (11%): This factor evaluates the borrower’s total debt, including loans and credit card balances.

• Recent credit behavior and inquiries (5%): This factor evaluates recent credit activity, including the number of new credit accounts and credit inquiries.

• Available credit (3%): This factor evaluates the borrower’s available credit, or the amount of credit they could access if they needed it.

VantageScores are used by a variety of lenders, including banks, credit card companies, and mortgage lenders. Like the FICO score, a good VantageScore can result in lower interest rates and better loan terms, while a poor score can lead to higher interest rates and less favorable terms.

Other Credit Scoring Models

• CreditXpert: It is a credit scoring model that’s designed to help lenders evaluate the risk of lending to borrowers with limited credit history. It uses alternative data sources, such as rent and utility payments, to assess creditworthiness.

• TransRisk Score: It is a credit scoring model that uses alternative data sources, such as public records and property records, to assess creditworthiness. It’s often used by lenders in the automotive industry to evaluate the risk of lending to borrowers with limited credit history.

• Experian’s National Equivalency Score: It assigns users a score of 0-1,000 based on payment history, credit length, credit mix, credit utilization, total balances, and the number of inquiries, but the criteria and weight are not publicly disclosed. The scoring system is different from the FICO model, with a score of 100 indicating a 10% chance of at least one account becoming delinquent in the next 24 months and a score of 900 indicating a 90% chance. A more familiar alternative scoring method of 360 to 840 is also provided.

Regulatory Environment and Credit Scoring Models: What You Need to Know

The regulatory environment surrounding credit scoring models is constantly evolving, and it’s important for both lenders and borrowers to stay informed about any changes that may affect lending decisions.

One significant development in recent years is the adoption of the VantageScore model by the three major credit bureaus. This model was developed as a competitor to the FICO score and uses a slightly different set of criteria to calculate a credit score. However, the VantageScore model has been gaining traction and is now widely used by lenders.

Another important development is the use of alternative data sources in credit scoring models. This includes data such as rental payments, utility bills, and even social media activity. While the use of alternative data can help lenders evaluate borrowers who may not have a traditional credit history, it also raises concerns about privacy and potential biases.

Regulators are also paying closer attention to the fairness and transparency of credit scoring models. The Consumer Financial Protection Bureau (CFPB) has issued guidelines for lenders to ensure that credit scoring models are transparent and unbiased. Additionally, the Equal Credit Opportunity Act (ECOA) prohibits lenders from using credit scoring models that discriminate against certain groups of borrowers.

The Future of Credit Scoring Models: Innovations and Trends to Watch Out For

As technology continues to advance, credit scoring models are evolving to keep pace with the changing landscape. Here are some emerging trends and technologies in credit scoring to watch out for:

Big Data: 

The use of big data and machine learning algorithms can help lenders analyze vast amounts of data to identify patterns and make more informed lending decisions. According to a study, 76% of lenders are already using machine learning in some capacity to evaluate creditworthiness.

Alternative Data: 

The use of alternative data sources, such as utility bill payments and rental history, is becoming more prevalent in credit scoring models. This can help lenders evaluate borrowers who may not have a traditional credit history and improve access to credit for underserved populations.

Real-Time Scoring: 

Real-time credit scoring can provide lenders with up-to-date information on a borrower’s creditworthiness, allowing for more accurate and timely lending decisions. This can be particularly useful for small business owners who need access to credit in a timely manner.

Mobile Scoring: 

With the rise of mobile banking, lenders are exploring the use of mobile data to evaluate creditworthiness. This includes analyzing a borrower’s mobile phone usage patterns, such as the frequency of calls and text messages.

Financial Health Scoring: 

Financial health scoring models are emerging as a way to provide a more holistic view of a borrower’s financial health. These models take into account factors such as savings, investments, and debt levels to provide a more comprehensive picture of a borrower’s creditworthiness.

Overall, the future of credit scoring models is exciting and full of potential. As new technologies and trends emerge, lenders and borrowers alike can expect to see more innovative and effective ways to evaluate creditworthiness and improve access to credit.

Streamline Your Credit Evaluations with HighRadius' Automated Scoring Models and Approval Workflows

HighRadius’ Credit Risk Management Software enables businesses to fast-track credit evaluations by leveraging configurable scoring models and approval workflows. By leveraging automated scoring models and approval workflows, businesses can streamline their credit evaluations, reduce risk, and optimize credit risk management. Here are the key features of the software:

Get a Consolidated View of Credit Risk Exposure Across ERPs:

View credit risk exposure across multiple ERPs in a consolidated manner, enabling businesses to identify potential credit risks and opportunities in real-time.

Centralize Global Credit Operations with Multi-Language, Multi-Currency Support: 

Centralize global credit operations with multi-language and multi-currency support, simplifying credit operations across geographies and business units.

Fast-Track Credit Reviews with Configurable Scoring Models: 

Tailor credit scoring criteria to specific needs and risk tolerance, fast-tracking credit reviews and evaluating creditworthiness accurately and efficiently.

Simplify Complex Credit Decisions with Automated Workflows: 

Streamline the credit approval process with automated workflows, reducing errors and speeding up the time to decision. This simplifies complex credit decisions, enabling businesses to make more informed lending decisions.

By automating credit scoring across the globe, expediting credit approvals with automated workflows, and leveraging configurable scoring models, businesses can improve overall efficiency and reduce risk. If you’re interested in learning more about how HighRadius’ Credit Risk Management Software can help your business, request a demo call today. Our team will be happy to walk you through the software and answer any questions you may have.

FAQs on Credit Scoring Models

1. What is the best model for credit scoring?

The best credit scoring model depends on the lender and borrower’s needs. FICO and VantageScore are the most commonly used in the US, based on factors such as payment history, credit utilization, and credit inquiries. However, credit scoring models are only one factor in credit decisions.

2. What is the most significant component for determining the credit score?

Payment history is the most significant component in determining a credit score. It includes factors such as payment timeliness, number of late payments, and severity of missed payments. Other factors like credit utilization, length of credit history, types of credit accounts, and recent inquiries also play a role.