Credit Scoring Models

Credit scoring models play a crucial role in determining an individual’s creditworthiness. They use various financial data points to calculate a credit score, which lenders rely on to assess the risk of lending. Two widely recognised models are the FICO Score and VantageScore. Both models evaluate factors like payment history and credit utilisation. However, they weigh these factors differently. A good score in either model can help you secure loans with favourable terms. Meanwhile, a poor score may result in higher interest rates and fewer credit options.

A credit scoring model is a system used by credit bureaus to evaluate a borrower’s creditworthiness. It analyses various financial factors, such as your payment history, credit utilisation, and length of credit history, to assign a numerical score. This score helps lenders/issuers assess the risk of lending money or extending credit to an individual. Popular credit scoring models include the FICO Score and VantageScore. Usually, the higher the score, the lower the risk related to lending to the loan and credit card provider. These models guide decisions on loan/credit card approvals, credit limits, and interest rates.

Credit scoring models are vital tools for assessing creditworthiness. They employ specific methods and criteria to generate a score. The score is then assessed by lenders/issuers to predict the risk of borrower default. Here are some of the most commonly used credit scoring models:

FICO Score

The FICO Score, developed by the Fair Isaac Corporation, is one of the most widely used credit scoring models. It evaluates a borrower’s creditworthiness based on five key factors, each carrying a different weight:

• Payment History (35%): Tracks whether you’ve made timely payments on past debts. Consistent on-time payments lead to a higher score.

• Credit Utilisation (30%): Measures how much of your available credit you’re using. Keeping this ratio below 30% improves your score.

• Length of Credit History (15%): Reflects how long your credit accounts have been active. A longer history positively impacts your score.

• Types of Credit Accounts (10%): Considers the variety of credit accounts you have, such as loans, credit cards, and mortgages. A diverse credit mix can boost your score.

• Recent Credit Inquiries (10%): Examines how often you’ve applied for new credit. Frequent applications may lower your score.

 

FICO scores range from 300 to 850, with higher scores indicating lower credit risk. They are commonly used by banks, credit card companies, and mortgage lenders to determine loan eligibility and terms.

VantageScore

The VantageScore was developed by three major credit bureaus as an alternative to FICO. These are Equifax, Experian, and TransUnion. Like the FICO Score, VantageScore ranges from 300 to 850. However the the weightage of its scoring factors differs:

• Payment History (40%): Similar to FICO, this evaluates how consistently you make payments

• Age and Type of Credit (21%): Consider the age of your oldest and newest accounts. It further takes into account the diversity of your credit types.

• Percentage of Credit Limit Used (20%): Assesses your credit utilisation, which is critical for maintaining a good score

• Total Balances and Debt (11%): Reviews your total outstanding debt, including loans and credit card balances

• Recent Credit Behaviour and Inquiries (5%): Monitors new credit activity and applications

• Available Credit (3%): Evaluates how much unused credit you have

 

VantageScore focuses more on credit utilisation and less on payment history compared to FICO  Scores. It’s increasingly popular among lenders due to its predictive capabilities and the use of trended data.

The credit risk scoring model is essential in modern finance. It provides a standard, objective way to assess the creditworthiness of individuals and businesses. This helps lenders evaluate the likelihood of loan repayment. It also allows them to make informed decisions on loan approvals, interest rates, and credit limits.

 

Without this model, lenders would rely on subjective judgments. This could lead to inconsistent evaluations and biased lending. By using uniform criteria, the model ensures fair assessments and promotes transparency. It streamlines the lending process, reduces defaults, and builds trust between lenders and borrowers.

Credit scoring models offer several advantages to both lenders and borrowers. Here's how:

Standardised Evaluation

Credit scoring models provide a consistent framework for assessing creditworthiness. This ensures all borrowers are evaluated using the same criteria. This helps eliminate biases and promote fair lending practices.

Objective Decision-making

Credit scoring models use data-driven algorithms to eliminate subjective judgments. This allows lenders to make objective decisions on loan approvals, interest rates, and credit limits.

Efficient Lending Process

These models streamline the credit evaluation process.  It enables lenders to quickly assess a borrower’s risk profile. This reduces the time required for loan approvals and enhances operational efficiency.

Reduced Risk of Default

Credit scoring models help lenders predict the likelihood of a borrower defaulting on a loan. By identifying high-risk applicants, lenders can take appropriate measures. These include offering secured loans or adjusting interest rates to reduce potential losses.

Better Terms for Borrowers

A good credit score can help borrowers secure loans at lower interest rates and more favourable terms. This can lead to significant savings over the loan’s tenure.

Promotes Financial Discipline

Understanding the factors that impact the credit score encourages responsible financial behaviour. This includes timely repayments and maintaining a healthy credit utilisation ratio.

Transparency and Trust

With clear criteria for evaluating creditworthiness, these models promote transparency in lending.  It helps borrowers understand their credit standing and build trust with financial institutions.

 

In India, the 4 major credit bureaus do not directly use the FICO Score or VantageScore models. Instead, they have their own scoring systems tailored to the Indian financial ecosystem.

Let’s understand how all 4 credit bureaus calculate your score:

TransUnion CIBIL

The CIBIL score, ranging from 300 to 900, is one of the most widely used credit scores in India. It’s calculated using factors like the payment history, credit utilisation, credit mix, and length of credit history. A higher score signifies lower credit risk. This improves your chances of securing loans at favourable terms.

Experian

Experian, another major credit bureau in India, uses a scoring model that ranges from 300 to 850. Similar to FICO, Experian evaluates payment history, outstanding balances, and recent credit inquiries. Experian scores are widely accepted by lenders to gauge borrower risk.

Equifax

Equifax provides credit scores ranging from 300 to 850. It assesses factors such as repayment history, credit utilisation ratio, and credit mix. Lenders use Equifax scores to evaluate credit risk and set loan terms accordingly.

CRIF High Mark

CRIF High Mark offers credit scores between 300 and 900.  It takes into account factors like payment patterns, length of credit history, and outstanding debts. Its reports serve both individual and business credit assessments.

India’s credit bureaus use scoring models tailored to the Indian market. These models don’t directly adopt global models like FICO Score or VantageScore. However, they do follow similar principles to assess creditworthiness. Knowing how these scores work helps you manage your financial profile. This boosts your chances of getting favourable loan terms.