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What do I need to know about credit scoring?

“Credit scoring” is a method that is being increasingly used by financial institutions to measure risk factors when financing SMEs. It is important for all businesses to understand the method used by banks to measure these risks as well as the benefits of obtaining a high score.

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Published by ConnectAmericas

“Credit scoring” is a method applied by banks to approve loans that uses scores to assess the potential credit risk of borrowers. A study undertaken by the Economic Commission for Latin America and the Caribbean (ECLAC) found that “credit scoring” is the most widely and successful tool used to facilitate financing of SMEs. For years this method has been extensively used in the United States to approve credit cards and other types of personal loans. In the past, lenders rarely used “credit scoring” to evaluate whether small and medium enterprises (SMEs) were credit worthy. Thanks to technological advances in credit reporting systems, financial institutions have extended their credit to SMEs by using this method, which consists of a statistical model used by banks to evaluate credit risks in an automated, objective and consistent manner. According to ECLAC, this tool helps create greater transparency in the market, allows SMEs to have additional financing options and reduces credit costs considerably. Although its use has increased significantly in recent years, some banks continue to consider the analyst´s judgment upon approving loans. It is necessary to count on a reliable system like the FICO score model which the United States has been using for decades. It is equally important that the borrower and the bank trust this model in order for it to be successful.

How do financial institutions apply the model?

Banks use this model to determine credit risks during two stages. First, at the beginning of the process during the application scoring where a minimum “cut-off” is introduced, depending on the level of risk and return on investment. Second, banks use the model to calculate the behavioral scoring of SMEs to measure other aspects of their performance once their loans have been secured, for example, to establish limits on credit cards and checking accounts, to identify profitable accounts, to offer new products, to monitor risk factors and to detect potential debt collection problems.

It´s very difficult to know what variables different entities use to measure credit risks since this information is rarely made public. However, we can learn from the experience of global markets, and more precisely from the FICO method. This model is the most commonly known and used method to calculate “credit scores” in the United States. It was introduced for the first time in 1989 by Fair, Isaac and Company (FICO), a pioneer business in the development of credit risk methods. Today, the FICO model --or different versions of it based on the original one -- are used by the majority of financial institutions in the United States and throughout the world. 

FICO’s method to determine credit risk:

Source: FICO

  • 35% Payment History: A good payment history largely impacts your score. Late payments of bills, mortgage loans, credit cards or any type of loans will have a negative impact on your credit score.
  • 30% Amounts Owed: the current revolving credit ratio (such as credit card balances) compared to the available or total credit limit. It is important to note that FICO scores can improve by paying down loans and lowering the credit utilization ratio.
  • 15% Length of Credit History: the length of your credit history or track record can positively impact your score. As long as your payment records are satisfactory, the longer you have been using lending tools, the higher your credit score will be in this category.
  • 10% Types of Credit Used: lenders can benefit from having different types of credit accounts, including installment loans, revolving line of credit, finance company accounts and mortgage loans.
  • 10% Requests for new credit: opening several credit accounts in a short period of time can lower your credit score, for example when applying for new credit cards or loans. 

Advantages of “credit scoring”

There are significant advantages to applying the “credit scoring” method. On the one hand, it reduces costs because it limits face to face interaction between banks and customers. Financial institutions can also approve loans based on the borrower´s credit history and the documentation submitted by the applicant electronically. Moreover, it dramatically speeds up loan approvals.

For example, a study by the International Finance Corporation (IFC) found that in Canada the loan approval period for an SME was reduced from 9 (there were maximum times of up to two weeks) to 3 days after 18 months of applying the “credit scoring” method. The same study found that the average processing loan fees for SMEs were reduced from US$250 to US$100.

The model not only benefits SMEs but also financial institutions. For example, it helps banks streamline loan processes, it reduces costs and it helps increase the number of approved loans. Moreover, access to the credit history of SMEs diminishes the need to obtain information about their financial statements, which is not only difficult to find but also unreliable.

Likewise, the model provides greater objectivity and transparency when approving loans since all borrowers must meet the same requirements, regardless of their size, sector or other discriminatory factors that might have been taken into account in the past.

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