Credit scores and how they are used by banks and mortgage companies to determine an applicant’s level of risk are something that we all have to undergo, but how are they calculated.
According to Fair, Issac and Company, Inc, a leading scoring model developer, it is quite possible that sixty variables will be considered when developing a model but only about twelve might end up in the final score card. In most scoring systems, the higher the score means the lower the risk. A lender may have a set cutoff score based on the amount of risk they are willing to take. If they followed the model carefully, the lender would approve all applicants whose score was higher than the cutoff and deny all applicants whose score was lower than that of the cutoff. Although this system is very accurate, it still cannot predict with certainty any individual’s loan performance. Even so, it should give a fairly accurate prediction.
In order to build a good scoring model, developers need a large amount of historical data that will reflect the loan performance of the applicant in both good and bad economical conditions. In the past, banks only used personal history, credit reports, and judgment to make credit decisions. During the past twenty five years however, credit scoring has become the way to go as far as applicant decisions for credit cards and any other form of credit. Scoring is now also used in mortgage origination. Both the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Corporation have encouraged the use of credit scoring.
Credit scoring has become such a necessity in the issuing of loans that even private mortgage companies are using it to screen their potential customers.