The Origins of Credit Scoring Systems

- by Kelly Richards

When someone lends money, the only question that matters is ‘will I get it back?’. So, before the existence of credit reference agencies how did lenders know whether or not the potential borrower was a good risk? In the past, lenders relied upon factors such as whether or not the person had previously had a loan and repaid it in full, whether they had a good reputation for steadiness and reliability and sometimes lenders paid a visit to see the home circumstances of the client. These were the only indicators that could be used to assess the reliability of the borrower when it came to making a decision about lending money.

The original scoring systems  in the UK relied mainly on trust.

Questions such as whether or not bills were paid on time, did they have a steady job and even personal habits such as cigarette smoking were taken into account before a loan was granted. So, decision making was ultimately based on the personal character of the borrower and the human judgement of the lender. However, as the amount of people who wanted to borrow money increased, this slow process was deemed to be unreliable and lenders began to standardise how the decision to lend was made.

The First Scoring Systems

A simple scoring system was developed but this was still very unreliable and lenders used different methods to allocate points making the method different every time from one lender to another. It was also still dependant upon judgement and as humans are flawed and often find it difficult to be impartial a new system was required that was based purely on mathematics.

The maths involved calculating the behaviour of real consumers and relied upon information from other lenders. This was achieved by studying a set amount of customers who had taken out a loan and it looked at which type of customer paid back the loan and which did not. The background of each customer who had a default was researched to see what they had in common. This allowed the mathematicians to build a scoring system that allocated points for certain common variables and all of these variables were used to create a credit score.

Making the systems fairer

Percentage points were assigned to such variables as the type of loan and the payment history of the customer and these two factors are still the most important for producing a reliable credit score. The principle behind the idea was that if the correct data is used it can improve the way lending decisions are made. This makes it a much fairer system than the system based solely on the decision of a person who may be biased for or against certain types of people who are not within the same social class.

The credit scoring system that was started in the 1950’s evolved into the FICO score and this is now used all round the world. It can help lenders to predict the behaviour of their clients regarding whether or not they will pay their bills on time and if they can handle credit in a sensible manner. The credit score also helps a lender to decide which clients are going to be the most profitable and which are most likely to default. They are also used by insurance companies to evaluate which customers are more likely to make a claim.

How are Credit Scores Made Up?

The information used to create a credit score is obtained from one or more of the three major credit reference agencies. In the UK these are Equifax, Experian and TransUnion. Equifax was established in the USA in 1899 by a pair of brothers who would keep a list of good paying customers. Then, they sold the list of customers to other people who supplied items on credit. Experian is the new kid on the block although it had its roots in the 19th century. Formed in 1996 by taking over an existing early type of credit agency, Experian now handles credit data about millions of customers. TransUnion started out by specialising in data regarding unpaid parking tickets but has recently established a new line of business that provides credit card authorisations from mobile phones.

The basic credit scoring range is from 300 to 850 and the higher the number the less risk the lender is taking. High scorers can also expect an offer of better interest rates than low scorers. The model behind the score is made up of the payment history which accounts for 35% of the score, the outstanding debts are also 30%, the time on file is 15%, credit enquiries are 10% and types of credit are also 10%. This is the basic model used although there are other models with some that give more weight to some sections than others. All customers can have access to their credit score to see how they have been assessed. But, it is important to remember that some areas of the score are more significant than the final total.

Comparing Credit reports

Credit scores for loans that are secured, such as a mortgage, are easier to identify as they are often based upon previous loans of a similar kind. Responsible payday loan lenders can use a credit score to place a person within a certain category of risk and by comparing the borrower to another one with the same kind of history they can assess the likelihood of default or bad payment. So, lenders will compare customers who have a long credit history with similar cases. This means that someone with a short credit history does not show up unfavourably by being compared to a borrower with a longer history. In order to make the system as fair as possible lenders only compare like for like.

The other main factors that are involved in making up a credit score are the amount you earn, any debts that you currently have and your residential status. Add to that your credit history and you will see that a credit score is a complicated equation. And, credit scores are not transferable from one country to another. So, you may have had a good score if you lived in the USA for a while but when you come to the UK you will have to start again and build up a new credit score even though the same credit reference agencies may be involved. Likewise, if you have a good credit score in the UK and go abroad to live for a a while, unless you maintain the lines of credit it will all be wiped out when you return home.

How to Check your Score

As you can see the factors that are involved in making up a credit score are varied and complex. Having a good score will allow you to get the best deals for most kinds of credit. Therefore, it is vital that your credit score is accurate. Don’t wait until you have been turned down for credit as this will only decrease your score even more. Applying to check your credit score rating is cheap and some agencies like Experian allow you a 30 day free trial to check your credit report. This offer only applies to new members and you can cancel the membership after the 30 days are up. However, if you want to pay a one off fee this is only £2.

When you have a copy of your credit report and credit score you should check it carefully to make sure that it is accurate. The report will show a list of all loans, credit cards and bank accounts. It will also show if you have made arrangements with utility companies and it will record whether or not payments have been made on time. Once recorded, late or missed payments stay on the report for 6 years. If you have ever taken out a loan in a joint venture this will also be shown as will any details of county court judgements or voluntary arrangements to pay off a debt. In addition, there will be a record of your current bank account provider and of any overdraft facility.

The record also shows personal details like your name and date of birth, whether or not you are on the electoral roll, your current address and previous ones and if you have ever been convicted of a fraudulent act this will also be shown. A credit report does not show information such as your current salary, your race or religious status or details of any criminal record.

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About The Author
Kelly Richards
Kelly Richards is the founder of the Cashfloat blog and has been working tirelessly to produce interesting and informative articles for UK consumers since the blog's creation. Kelly's passion is travelling. She loves her job because she can do it from anywhere in the world! Whether inspiration hits her while sitting on the balcony of a French B&B, or whether she is struck with an idea in a roadside cafe in Moscow, she will always make sure that the idea comes to fruition. Kelly's insights come from her knowledge gained while completing her degree in Economics and Finance as well as from the people she meets around the world. Her motto is: Everyone you meet has something valuable to teach you, so meet as many people as you can!
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