What Is the Function of a Credit Score?
Credit scores are ubiquitous. Nearly every adult over the age of 18 in the United States has ongoing, free access to their credit scores through a bank app or a financial website. This level of access represents a significant shift from just a few years ago, when credit scores were an opaque tool for lending professionals who used them to make decisions on applications (they still do!).
Nowadays, a person’s credit score is one of the main ties to their financial services provider. A credit score is a mathematical measurement, usually a three-digit number, based on your financial information that indicates the likelihood that you may default on a loan or other credit obligation. Default is typically defined as falling significantly behind (e.g., 90 days or more) on your payment obligation over a specific period.
It’s important to understand that a credit score does not provide an absolute prediction of whether a person will default. Instead, credit scoring models are designed to “rank order” a population. This means they compare consumers and rank them from most likely to default to least likely, based on their past credit history. In other words, credit scores measure relative probabilities, rather than absolute predictions.
Since credit scores rank a population, the risk that those scores represent shifts based on economic conditions (such as the unemployment rate or home values), changes in lending practices, or other factors.
The takeaway for consumers is that, because the credit score is not an absolute predictor of whether a person will default, lenders consider much more information (e.g., income, assets, employment history, and other factors) before making a loan decision. This information, in its entirety, enables a lender to determine whether a person can repay a new loan.
How Lenders Use Credit Scores?
A credit score model is one factor lenders often use to determine whether to extend credit to you. When evaluating an application, they also consider other factors, such as income and employment history. If your score is low, a lender might use different information to determine whether to approve you for a loan and at what terms.
Your credit score is not a judgment of whether you’re good or bad with money. With VantageScore 4.0, your score is based only on the information in your credit report, like your payment history and balances, not your income, savings, or overall financial situation. Other credit scores, like VantageScore 4Plus, can factor in your bank account information with your permission.
What Happens When You Apply for a Loan?
For many people, the process of taking out a loan may seem very simple. You fill out some paperwork, wait a few days, and then you find out whether you’ve been approved. However, the process is far more complex from the lender’s perspective.
Step 1: The Application
Applying for a loan is really the only part of the process where the consumer has direct involvement. A consumer either goes to a mortgage broker, auto dealership, their credit union, or applies online via a lender’s website. What all these options have in common is a formal request by a consumer to borrow money for either buying a large-ticket asset, such as a house or car, or for another purpose, such as paying off credit card debt. As it pertains to credit, when you fill out and submit an application, you’re providing what is referred to in the Fair Credit Reporting Act as “Permissible Purpose” to the lender. Permissible purpose is a legal term that indicates the lender and the credit bureaus have a legal right to obtain and provide your credit report or credit reports in response to your application.
Step 2: Risk Assessment
Once you’ve formally applied and given the lender legal permission to access your credit reports and credit scores, they will do so. This is commonly referred to as a credit “inquiry.” Most lenders have relationships with one, two, or all three of the credit reporting companies or an authorized reseller of their credit report information, and they will “pull” your information from one or more of those companies.
For clarity, do not assume the only thing lenders care about is the quality of your credit reports and credit scores. Lenders will also consider factors such as your debt-to-income ratios, your employment status, the loan-to-value ratios for secured loans, and the information on your applications.
Step 3: The Decision
Once the lender has procured your credit reports, scores, and other information used for risk assessment, this information is juxtaposed against the lender’s decision criteria. This is the point in the process at which the lender decides whether to approve your loan application.
If you meet all of the lender’s decision criteria, which include many credit-specific criteria, you will be approved. If you do not meet the lender’s decision criteria, you will be denied.
If your loan application is denied and the decision was based on your credit information, the lender is required to send you what’s formally referred to as a Notice of Adverse Action. Most people refer to these notices as denial letters. This letter will advise you of the lender’s decision and also provide a great deal of information about your credit reports, credit scores, and your rights. If your application has been approved, you will move on to Step 4.
Step 4: Funding the Loan
If you’ve been approved, the lender will notify you, likely within a few hours or days. If you’ve applied for an auto loan, you may be able to drive away in your new car within a few hours. If you’ve been approved for a mortgage loan, the process of funding may take a few weeks.
For mortgage loans, you will go through a process called “closing.” This is generally, but not always, performed by a real estate attorney. The closing attorney will meet with the buyers and sellers of a home and collect signatures on essential documents from each side. The closing attorney will also collect funds from the bank and, if necessary, from the buyer. In essence, the closing attorney ensures the process is formalized and that everyone is either paid or gets paid appropriately.
Step 5: You’re Now a Borrower
Once a loan is closed, regardless of the loan type, the consumer formally becomes a borrower, obligor, co-obligor, or debtor. These terms all mean the same thing, which is that you now owe money to some company. That company is referred to as your lender or creditor.
There are various types of lenders. Banks, credit unions, finance companies, and credit card issuers are all considered lenders. You can take out loans from most, if not all, lenders. Even some companies that are traditionally recognized as credit card issuers offer loans.
Step 6: The Furnishing of Data to Nationwide Consumer Reporting Agencies
Many, if not most, lenders will begin to report your loan to the credit reporting companies within a few weeks or months after your loan is approved. This process is formally referred to in the Fair Credit Reporting Act as “furnishing,” as your lender will furnish information about your loan to the Nationwide Consumer Reporting Agencies: Equifax, Experian, and TransUnion (“NCRAs”).
The information furnished by your lender to the NCRAs will include data attributes such as the date your account was opened, the original loan amount, the balance, and your payment history. And, if you’ve missed payments or have defaulted on the loan, that information will be furnished as well.
Most lenders provide updated information to the NCRAs once a month, though it may occur more or less frequently. This information is collected by the NCRAs from thousands of companies and aggregated with other information about you into what’s commonly referred to as a credit report. You have the right to check your credit report once every 12 months from the major NCRAs via the website www.annualcreditreport.com.
Step 7: The Scoring of Your Data
Once information about your loan reaches the NCRAs, it becomes scorable by the credit scoring models commonly used by lenders and other companies. The process occurs when the NCRAs compile the information associated with you in their systems and apply a scoring model to the data. This is commonly and informally referred to as “calculating your credit score.”
This process can occur for various reasons. For example, if you apply for another loan, credit card, or some other service, the lender or service provider can request your credit score. And many websites provide free credit scores to their registered users periodically. You can find a list of those companies here.
Step 8: Paying Off Your Loan
There are a variety of ways to pay off your loan. You can make your scheduled monthly payments. You can make some of your monthly payments, then make a lump sum payment to exhaust the remaining balance. Or you can sell the collateral and use the proceeds to pay off the remaining loan amount. That’s what happens when you sell your house.
Once your loan is paid off, the lender will update your credit reports to reflect the new zero balance. If the loan is in good standing, it will remain on your credit reports for the next ten years. If the loan defaults, it will be removed no later than 7 years from the date of default.
For more information and helpful tips, visit https://vantagescore.com/consumers.
