How Lenders Use Credit Scores

Regardless of the particular credit model used to compute your credit score, your credit score is based on an analysis of your credit history and on statistics.  Studies have shown that a credit score is a very accurate way to measure an individual's creditworthiness.  The scores predict how individuals will act in the future when it comes to financial matters- and the scores are grouped into the categories based on the general population so that a sample can be taken from any range of credit score and a lender will have a good representation of what to expect from people who fall within those credit score ranges.

The Goal of Credit Score Models

Credit score models (FICO, Beacon, etc) all share the same overall goal:  to identify people who are considered a "good credit" risk, and to identify people who are considered a "bad credit" risk.  If the formula used to generate credit scores is overly severe, people who could actually be a good risk to lenders will be eliminated and lenders will lose money as they will not have enough people to lend money to.  If the scoring model has an overly relaxed formula, then people who are not good credit risks may have high enough credit scores to obtain lending and the profits for lenders will be hurt as well since some of the people they lend money to will be unable to pay back the borrowed money. 

What Lenders do With Credit Scores

Lenders place a lot of value upon credit scores for determining whether or not someone is credit worthy-  and they also use specific scores in order to determine what interest rate to give to borrowers based on statistics.

Statistics show lenders specifics.  For example, lenders can figure out how many people out of 100 borrowers in the 500-600 credit score range will default on their loan- and then use that information to determine what interest rate to give this group of borrowers and how many borrowers in that group they should lend to at any given time in order to maintain a good risk portfolio and maximize their profits.

With statistics, lenders set up charts and computer programs that allow them to determine whether or not to lend money to an individual and at what interest rate to lend it- all based on credit scores and previous histories of individuals with that same credit score.

Example Lending Process

A person with a credit score of 550 requests a loan from a lender.  The computer system in the lender's office checks the credit score by performing a series of checking.  If the credit score is 700 or more, the lender will loan the money at the lowest interest rate.  If the credit score is less than 700, the system would check to see if the score was above 650.  If the score is more than 650, the lender would lend money at a higher interest rate.  If the score is greater than 600, the lender will lend money at an even higher interest rate, maybe 15-20%.   In our example, the individual still does not have a high enough score, so the system would continue to check against their requirements.  The lender might say that any score that is less than 600 does not achieve lending- so in this case, the individual would be denied credit.