Reviewed by Sep 30, 2020| Updated on
Credit scoring is a statistical analysis that lenders and financial institutions conduct to access the creditworthiness of an individual. Lenders refer to credit scores to decide whether to extend or refuse credit. A credit score for an individual is a number between 300 and 850, 850 being the highest possible credit rating. A credit score impacts financial transactions, such as credit cards, mortgages, car loans, and personal loans.
A credit score is influenced by five factors—payment history, types of credit availed so far, new credit, current debt, and length of credit held. The lender needs to pay special attention to current debt and payment history.
Lenders use credit scoring in risk-based pricing, in which the terms of a loan provided to lenders, including the interest rate, are based on the likelihood of repayment. Generally speaking, the higher a person's credit score, the better the interest rate the financial institution provides to the customer.
There should be no confusion between similar concepts, credit ratings and credit scoring. Credit ratings are valid for companies, sovereigns, sub-sovereigns, and securities of those entities as well as securities backed by assets.
Credit scoring models reflect a picture of your credit relationship and scores can differ (although not drastically) between the three major credit bureaus. A credit rating defines both the interest rate for the loan and whether a credit or debt issue will be accepted for the borrower.
Although credit scoring rates the credit risk of a borrower, it does not provide an estimation of the likelihood of a borrower being defaulted. It only measures the probability of a borrower from the highest to the lowest as an ordinal rating. Credit scoring, therefore, suffers from its failure to determine whether Borrower A is twice as risky as Borrower B.