Credit Scores and Scorecard Lending

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Credit Scores and Scorecard Lending
Slide Show 12

• AGEC 489/690
• Spring 2009

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Credit Scoring Fundamentals
A credit score is a numerical expression based on
a statistical analysis of a borrowers credit
history to represent his/her creditworthiness,
which is the likelihood that the borrower will
pay his/her debts in a timely manner.
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Credit Scoring Fundamentals
A credit score is a numerical expression based on
a statistical analysis of a borrowers credit
history to represent his/her creditworthiness,
which is the likelihood that the borrower will
pay his/her debts in a timely manner. A credit
score is primarily based on credit report
information obtained from credit bureaus and
credit reference agencies.
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Credit Scoring Fundamentals
Lenders use credit scores to evaluate the
potential risk posed by lending money and to
mitigate losses due to bad debt. Lenders also
use credit scores to determine who qualifies for
a loan, at what interest, and what credit
limits.
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Credit Scoring Fundamentals
Lenders use credit scores to evaluate the
potential risk posed by lending money and to
mitigate losses due to bad debt. Lenders also
use credit scores to determine who qualifies for
a loan, at what interest, and what credit
limits. Credit scoring is not limited to
lending. Other organizations, such as mobile
phone companies, insurance companies, and
potential employers are examples of other users
of credit scoring.
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Fundamentals Credit Scoring
A credit score is primarily based on credit
report information typically from the three US
credit bureaus Experian, TransUnion and
Equifax.
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Fundamentals Credit Scoring
A credit score is primarily based on credit
report information typically from the three US
credit bureaus Experian, TransUnion and
Equifax. There are differing approaches to
calculating credit scores. The FICO is a credit
score developed by Fair Issac Company. It is
used by many mortgage lenders that use a
risk-based system to determine the possibility
that the borrower may default on financial
obligations to the lender.
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Fundamentals of a Credit Report

• Personal identifying information your name,
  address, social security number, birth date,
  current and previous employers.

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Fundamentals of a Credit Report

• Personal identifying information your name,
  address, social security number, birth date,
  current and previous employers.
• Credit history this includes your bill-paying
  history with banks, retail stores and others who
  have granted you credit. Information includes
  each account you have (when opened, type of
  account, how much credit it includes and amount
  used, your monthly payment. It will indicate when
  loan was paid off and if there were missed or
  late payments.

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Fundamentals of a Credit Report

• Personal identifying information your name,
  address, social security number, birth date,
  current and previous employers.
• Credit history this includes your bill-paying
  history with banks, retail stores and others who
  have granted you credit. Information includes
  each account you have (when opened, type of
  account, how much credit it includes and amount
  used, your monthly payment. It will indicate when
  loan was paid off and if there were missed or
  late payments.
• 3. Public records information that might
  indicate your creditworthiness, such as tax
  liens, court judgments and bankruptcies.

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The FICO credit score is used by all three US
credit bureaus. It is used by over 90 of
commercial banks when analyzing mortgage loan
applications.
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FICO Credit Score Employed In Lending Decisions
350
500 580 620 660 700 760
850
Loan automatically rejected below 500
Loan automatically accepted above 500
More information required. Risk premium applied
to interest rate.
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930 difference in monthly loan payment!!!!
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Scorecard Lending
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Credit Standards

• Most lenders use credit scores as a part of its
  standards when evaluating loan applications.
• Lenders also establish standards related to
  liquidity, solvency and debt repayment capacity
  (for example, a minimum current ratio of 1.50, a
  maximum debt ratio of 0.50, minimum term debt and
  capital lease coverage ratio of 1.25).

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Hypothetical Scorecard
Points Points Available Achieved

• Credit score from credit bureau 15 ________
• Current ratio 15 ________
• Debt ratio 20 ________
• Debt coverage ratio 30 ________
• Other factors 10 ________
• a. Continuing customer
• b. Primary commodity
• c. External control factors
• TOTAL SCORE ________

The lender then decides the minimum score for
automatic approval, automatic rejection, and
range over which additional conditions must be
met (risk premium, additional collateral,
compensating balances, etc.
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Hypothetical Scorecard
Points Points Available Achieved

• Credit score from credit bureau 15 ___12___
• Current ratio 15 ___13___
• Debt ratio 20 ___17___
• Debt coverage ratio 30 ___25___
• Other factors 10 ____9___
• a. Continuing customer
• b. Primary commodity
• c. External control factors
• TOTAL SCORE ___76___

The lender then decides the minimum score for
automatic approval, automatic rejection, and
range over which additional conditions must be
met (risk premium, additional collateral,
compensating balances, etc.
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Credit Score Lending Sheet
0
50 55 60 65 70 75 76
100
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Loan automatically rejected below 50
Loan automatically accepted above 75
More information required. Risk premium applied
to interest rate.
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Hypothetical Loan Rates
Base cost of funds 4.0
Score gt 75 6.0
Score 71 75 7.0
Score 66 70 7.5
Score 61 65 8.0
Score 56 60 8.5
Score 50 55 9.0