Credit_Scoring by MarijanStefanovic


Credit Scoring

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Credit scores and how they are used by banks and mortgage companies to
determine an applicants level of risk, are something that we all have to
undergo, but how are they calculated.

credit report

Article Body:
Credit scores are used to determine the credit risk of loan applications.
This is done using historical data as well as statistical techniques.
The score can be used by banks to produce a rank for the loan applicants
and borrowers in terms of risk factors.

To build this model developers analyze historical data of previously made
loans. They do this to determine which borrower characteristics will
help them to predict whether the loan had a good performance or not. The
better the model design, the higher the percentage will be. A higher
percentage of high scores are awarded to borrowers whose loans perform
well and a lower percentage is given to those whose loans do not.
However, no model is absolutely perfect so some bad accounts receive
higher scores then some of the better ones.

Reports on borrowers come from loan applications and from the credit
bureaus. They will contain such information as the applicants' monthly
income, their outstanding debt, their financial assets, how well they
performed on a previous loan, whether they own a home or rent one, the
type of bank they use, and even how long they have been at their job.
The regression analysis relating loan performance to the many variables
is used to discover which combination of factors will best predict how
much weight each factor should hold. Because of the correlations between
each of the factors, it is very possible that some of the factors the
model developer begins with will not be in the final model, due to little
value added considering the other variables in the model.

According to Fair, Issac and Company, Inc, a leading scoring model
developer, it is quite possible that sixty variables will be considered
when developing a model but only about twelve might end up in the final
score card. In most scoring systems, the higher the score means the
lower the risk. A lender may have a set cutoff score based on the amount
of risk they are willing to take. If they followed the model carefully,
the lender would approve all applicants whose score was higher than the
cutoff and deny all applicants whose score was lower than that of the
cutoff. Although this system is very accurate, it still cannot predict
with certainty any individual's loan performance. Even so, it should
give a fairly accurate prediction.
In order to build a good scoring model, developers need a large amount of
historical data that will reflect the loan performance of the applicant
in both good and bad economical conditions. In the past, banks only used
personal history, credit reports, and judgment to make credit decisions.
During the past twenty five years however, credit scoring has become the
way to go as far as applicant decisions for credit cards and any other
form of credit. Scoring is now also used in mortgage origination. Both
the Federal Home Loan Mortgage Corporation and the Federal National
Mortgage Corporation have encouraged the use of credit scoring.

Credit scoring has become such a necessity in the issuing of loans that
even private mortgage companies are using it to screen their potential

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