Credit Scores and Scorecard Lending AGEC 489/690 Spring 2009 Slide Show #12

Credit ScoringFundamentals Credit Scoring Fundamentals creditworthiness A credit score is a numerical expression based on a statistical analysis of a borrower’s credit history to represent his/her creditworthiness, which is the likelihood that the borrower will pay his/her debts in a timely manner.

Credit ScoringFundamentals Credit Scoring Fundamentals creditworthiness A credit score is a numerical expression based on a statistical analysis of a borrower’s credit history to represent his/her creditworthiness, which is the likelihood that the borrower will pay his/her debts in a timely manner. A credit score is primarily based on credit report information obtained from credit bureaus and credit reference agencies.

Credit ScoringFundamentals Credit Scoring Fundamentals potential risk who qualifies for a loan, at what interest, and what credit limits Lenders use credit scores to evaluate the potential risk posed by lending money and to mitigate losses due to bad debt. Lenders also use credit scores to determine who qualifies for a loan, at what interest, and what credit limits.

Credit ScoringFundamentals Credit Scoring Fundamentals potential risk who qualifies for a loan, at what interest, and what credit limits Lenders use credit scores to evaluate the potential risk posed by lending money and to mitigate losses due to bad debt. Lenders also use credit scores to determine who qualifies for a loan, at what interest, and what credit limits. potential employers Credit scoring is not limited to lending. Other organizations, such as mobile phone companies, insurance companies, and potential employers are examples of other users of credit scoring.

Fundamentals Credit Scoring A credit score is primarily based on credit report information typically from the three US credit bureaus: Experian, TransUnion and Equifax.

Fundamentals Credit Scoring A credit score is primarily based on credit report information typically from the three US credit bureaus: Experian, TransUnion and Equifax. There are differing approaches to calculating credit scores. The FICO is a credit score developed by Fair Issac & Company. It is used by many mortgage lenders that use a risk-based system to determine the possibility that the borrower may default on financial obligations to the lender.

Fundamentals of a Credit Report 1.Personal identifying information – your name, address, social security number, birth date, current and previous employers.

Fundamentals of a Credit Report 1.Personal identifying information – your name, address, social security number, birth date, current and previous employers. 2.Credit history – this includes your bill-paying history with banks, retail stores and others who have granted you credit. Information includes each account you have (when opened, type of account, how much credit it includes and amount used, your monthly payment. It will indicate when loan was paid off and if there were missed or late payments.

Fundamentals of a Credit Report 1.Personal identifying information – your name, address, social security number, birth date, current and previous employers. 2.Credit history – this includes your bill-paying history with banks, retail stores and others who have granted you credit. Information includes each account you have (when opened, type of account, how much credit it includes and amount used, your monthly payment. It will indicate when loan was paid off and if there were missed or late payments. 3.Public records – information that might indicate your creditworthiness, such as tax liens, court judgments and bankruptcies.

The FICO credit score is used by all three US credit bureaus. It is used by over 90% of commercial banks when analyzing mortgage loan applications.

Loan automatically rejected below 500 Loan automatically accepted above 500 FICO Credit Score Employed In Lending Decisions More information required. Risk premium applied to interest rate. More information required. Risk premium applied to interest rate.

4.467 % risk premium % risk premium

4.467 % risk premium % risk premium $930 difference in monthly loan payment!!!!

Scorecard Lending

Credit Standards Most lenders use credit scores as a part of its standards when evaluating loan applications. Lenders also establish standards related to liquidity, solvency and debt repayment capacity (for example, a minimum current ratio of 1.50, a maximum debt ratio of 0.50, minimum term debt and capital lease coverage ratio of 1.25).

Hypothetical Scorecard 1.Credit score from credit bureau 15 ________ 2.Current ratio 15 ________ 3.Debt ratio 20 ________ 4.Debt coverage ratio 30 ________ 5.Other factors 10 ________ a. Continuing customer b. Primary commodity c. External control factors TOTAL SCORE ________ Points Points Available Achieved The lender then decides the minimum score for automatic approval, automatic rejection, and range over which additional conditions must be met (risk premium, additional collateral, compensating balances, etc.

Hypothetical Scorecard 1.Credit score from credit bureau 15 ___12___ 2.Current ratio 15 ___13___ 3.Debt ratio 20 ___17___ 4.Debt coverage ratio 30 ___25___ 5.Other factors 10 ____9___ a. Continuing customer b. Primary commodity c. External control factors TOTAL SCORE ___76___ Points Points Available Achieved The lender then decides the minimum score for automatic approval, automatic rejection, and range over which additional conditions must be met (risk premium, additional collateral, compensating balances, etc.

Loan automatically rejected below 50 Loan automatically accepted above 75 Credit Score Lending Sheet More information required. Risk premium applied to interest rate. More information required. Risk premium applied to interest rate. 49

Hypothetical Loan Rates Base cost of funds4.0% Score > 756.0% Score = 71 – 757.0% Score = 66 – 707.5% Score = 61 – 658.0% Score = 56 – 608.5% Score = 50 – 559.0%