DID YOU KNOW?: What is the function a credit score serves?
What does a credit score do and (more importantly) what does it not do.”
Credit scores are ubiquitous. Nearly every adult in the United States has ongoing, free access to their credit scores with the click of a mouse or through your mobile device. This is a major departure from just a few years ago when credit scores were a tool for “back office” lending professionals who used them to make decisions on applications (they still do!).
But nowadays, a person’s credit score is one of the main tethers someone has to their financial services provider. And with that access and engagement, misconceptions have risen. That’s why in the next few issues of THE SCORE, we’ll tackle some of these issues.
First and foremost, one of these concepts is fundamental: what is the function a credit score serves?
Below are “facts and fictions” about what credit scores actually do.
FACT: 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 (for example, 90 days or more) on your payment obligation over a certain period of time.
FICTION: A credit score provides an absolute prediction of whether a person will default (i.e., going 90 days or more late) on a loan.
EXPLANATION: A credit score model “rank orders” a population which means it compares that population and provides a ranking of consumers from most likely to default to least likely to default, where typically a higher score represents a lower likelihood of default compared to a lower score – this is different than an absolute prediction. To keep it simple, if a credit score were assigned to ten people only, it would rank those people in order of most likely to least likely to default, based on their past credit history.
Because the credit score model ranks 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 take-away for consumers is that because the credit score is not an absolute predictor of whether a person will default, a lender takes much more information (e.g., income, assets, employment history and other factors) into consideration before making a loan decision. This information in its entirety enables a lender to make judgements on whether a person has the ability and is likely to repay a new loan.
FACT: A credit score model is one factor lenders often use to determine whether to extend you credit.
FICTION: A credit score is a measurement of a person’s overall financial health.
Often times a credit score is taken as an overall report card on how a person is doing financially. This is not the right way to interpret your credit score. Your credit score does not factor in how much money you make, how much money is in your checking and savings accounts, whether you have a retirement account or whether you have valuable assets like real estate.
This difference is important because lenders factor in many of these other pieces of information into their decisions. So if your score is low, a lender might use other information to determine whether to approve you for a loan and at what terms.
Secondly, understand that your credit score is not a reflection on whether your overall financial picture is good or bad. Rather, when it comes to models like VantageScore, it is a reflection of what information resides in your credit file.