Making Sense of Credit Scoring

by Adam Smith02 Dec 2013

Clean Credit’s John Dickinson explains new information available from credit reporting agencies

You are no doubt aware that Veda Advantage is now offering credit scores for consumers; this information was previously only available to credit providers.

While there has been a lot a media about this, very little has covered how credit scoring actually works.
 
While I think revealing a consumer’s credit score is a positive change, it equates to little without the ability to correctly interpret what it actually means; after all, without this knowledge it’s just a number. We are often asked the question “what should my credit score be?” This can be a difficult question to answer as different credit providers can carry different credit policies and risk acceptance. This is evidenced by the fact a number of brokers have told us about situations where one lender will decline an application due to a credit score while another lender will approve the same matter. With this point in mind I can give you a good guide to follow.
 
Other than a bankruptcy, the lowest credit score a person can have is -200 with the highest being +1,200. The higher the score the better, however as a general rule we like to see people with a credit score of at least +600. Having a credit score of +600 or more is not in itself a guarantee of approval but we see most people with credit scores in that region who are not experiencing difficulty securing credit. I’m not suggesting that people with a credit score of less than +600 will be unable to secure finance, however they will most likely have less choice and may find themselves paying higher interest rates and fees as a result.
 
A credit score is a moving target and is subject to change due to a number of factors such as credit enquiries, changes of address or employment, along with negative listings such as defaults and court actions.
 
Let’s take a look at how the credit providers use a credit score to determine the risk profile of an applicant.
 
According to Veda Advantage a credit score of +200 represents odds of 1:1 which means the applicant has a 50% chance of having an adverse event on their credit file within the next 12 months. For every additional 100 points the odds double, meaning the applicant has less chance of having an adverse event on their credit file. The table below reflects this.
 
Veda Score
Click image to enlarge
 
Let’s say your client has a credit score of +300; according to this scoring system they have a 33% chance of having an adverse credit event in the next 12 months – even a credit score of 400 still shows as a 20% chance.
 
With this understanding it’s clear why a borrower may experience difficultly securing credit with a poor credit score.
 
Credit scoring can be an effective tool for credit providers to quickly determine risk. Imagine how many applications a large institution such as a bank receives each day; triggering their credit systems to react to a certain credit score is a quick way for them to process and approve or decline applications.
 
I’m sure that many credit providers themselves feel that the way credit scoring operates is a broad brush approach and as a result many people do not qualify for finance when in reality they would prove to be reliable and credit worthy. The problem of course is credit providers subscribe to organisations such as Veda Advantage to help them determine risk and not applying these principles to their risk assessment process would defeat the purpose from their perspective.