The Theory behind Credit Reports and Credit Scores

Most of us have to borrow mony from a bank or similar institution on some point in life, be in the forms of our mortgages or loans to buy cars or credit cards for convenient ongoing borrowing.

Today’s western society is to some extent depend on those organisations that are willing to lend us money and while some may argue that debt is bad, the distinction between credit and debt has to be made. The BBC in a recent article suggested that UK debt is at 'time bomb' levels .

Debt, is without a doubt a burden to some, relatively access to credit, when well managed to can help both society in general and individual aspirations grow in leaps and bounds.  Credit Scoring is an excellent system that determines an individual has more debt that they can effectively handle, or whether any credit extending to an individual is relatively low risk. 

So what exactly is the specie mechanism used to calculating how much of a risk is associate with lending to a specific individual? Alas, this varies from institution to institution and as such we will need to have a look at as representative a case study as we could find.. For this case study, we have selected the processes that are used in a typical American Express Credit Card Application, major uk banks used to assess risk with their financial products in our own recent applications.

Several data sources are used to do this.

Application Forms

Your application form will be used to obtain core information such as  basic information including your name, age and address  the amount that is required and also what the money is required, you level of earning and whether or not you are a home owner. In some cases some of this data may be pre-filled on the application for you.

In addition to your personal details, the lender will also gather data which may seem irrelevant to us, but has been found through tests to be a reliable indicator of other the presence or absence of other background risk, for example, whether you are married, single or divorced? How exactly these are factored in is unclear, but this data appear to be used be correlated with historic correlations.

Credit Files

The lender will carry out a search with their preferred credit reference agency to establish whether or not you are creditworthy. The main ones used in the UK are Experian, Equifax and Callcredit which all hold information gleaned from the electoral roll such as your address details and the names of others who live at the property. They also contain details of any County Court Judgements and bankruptcies. Alongside that will be information passed on to them from various banks and building societies about your payment history for cards, loans, mortgages etc, that you already have.

Not all financial organisations share all the information they have on you with all three of the agencies, and most only refer to one of them when checking you out, so it's quite likely that one agency does not hold a complete record of your credit history. However, since your payment records will affect how you decide to manage your finances, it's important that the information any agency holds about you is up-to-date and correct.

So, what does a prospective lender see when they bring up your credit file?

Number of searches

Each time your files is searched by a potential lender, the search is registered. A high number of such searches in a 3-6 month period may be viewed as a desperate attempt to borrow and lead to reduction. However, lately many banks are being to realise that online comparison engine that allows you to compare secured loans often result in a high frequency of searches as the borrow does their due diligence and shops around for the most sensible deal.

Years in present employment

Points

0-5

0

6-10

+15

11-12

+30

13 or over

+ 50

Marital status

Divorced

0

Widowed

+10

Single

+12

Married

+40

Age

21-25

0

26-30

+5

31-39

+40

40-59

+55

60 or over

+42

Number of Children

None

+30

1

+15

2

+5

3 or more

0

Age of most recent bad debt

No debts

+5

Less than 3 months

-35

3-12 months

-30

1-2 years

-27

2-3 years

-15

Associations

This is only appropriate if you have a joint bank account, mortgage or credit card; you have a "financial association" with someone else, say, your spouse, for example. This is a decreasing trend but may be the case.  Where the person you are associated with has a bad credit records, this may affect your chances of being able to borrow.

Credit Scores

Your credit score is essentially a relative measure of how much or little risk is associated with lending to you based on the aforementioned factors, is calculated by each lender using a unique formula and can vary from institute.

Its is quite possible that, depending on the formula used,  your credit rating will be affected by your age, and children could be regarded as a liability by the lender.! Other factors that affect your credit score may include your profession (some are viewed more favourably than others), the length of time you've lived at a particular address, whether you're a homeowner and even whether you have a landline telephone. Your postcode may also be used as this can be used to determine how affluent your area is.

One crucial thing that keeps coming up is the electoral role. Many lenders will immediately discount your application if you do not appear on this, so always make sure that this is updated when you move address by ensuring that you are registered for council tax and or by phoning the council directly.