Credit Scoring Explained

There has been a lot written on Internet discussion forums and financial websites about credit scoring. Most of this is based on personal experience, assumptions and hearsay. We, at makesenseofcards.co.uk, would be the first to say that sharing information and customer experience is immensely valuable, but we felt that there was a real need to get the view from within the industry rather than from the outside.

To research this article we spoke to the leading Customer Reference Agency, Experian , and to an industry professional who has worked for both a Credit Reference Agency and for a number of financial services companies as the manager of a lending portfolio. Although this article contains a detailed insight into credit scoring, it is important to realise that each lender has their own criteria for making lending decisions and will have their own policy rules.

Who is involved in making a lending decision?

There are normally 3 parties involved in a lending decision

• The borrower who is applying for a credit card (i.e. you or me). The borrower completes an application form, which provides the lender with lots of information about the applicant. This information is all entered into the credit scoring process.
• The lender i.e. the credit card company. When making a decision whether or not to lend money to you, the lender needs to establish that you are who you say you are, whether you can handle the credit that they might offer, whether there is a risk that they will lose money if you can not pay it back, and whether you are likely to be a profitable customer. In order to do this, they will give you a credit score based on the information that you have provided on your application form together with information that they obtain from a Credit Reference Agency (CRA). When a lender requests information from a CRA, it is known as a “credit search” or “credit check”.
• The Credit Reference Agency (CRA). CRAs collate information from various sources including the electoral roll, other lenders and publicly available information such as County Court Judgements, Bankruptcies and IVAs (Individual Voluntary Arrangements). They use this information to tell the lender that you are who you say you are and to provide them with your credit history. If required, a CRA can also produce a credit score for the lender, but most lenders in the UK do their own credit scoring.

The Credit Assessment Process

When assessing your credit worthiness, there are three major cornerstones that underpin the whole process.

1. The Credit Score. The Credit Score is a single measure of a borrower’s creditworthiness, based on the information available to the lender. The score reflects the likelihood of the borrower’s performance being ‘good’ over a given period of time: usually 6 months to 2 years. The higher the borrower scores, then the more likely his/her performance will be ‘good’. To be classified as ‘good’, it helps if the applicant has a similar profile to those people who the lender has previously found to be good.
2. Policy Rules. Each lender has its own policy rules, which include a definition of how the credit score will be used and what decision to make based on that score. It will define at what point they will accept an application, decline it or refer it to an underwriter for a manual assessment. Other policy rules may override the credit score, for example rules that are in place for anti-money laundering or fraud prevention. Another rule could mean that they decline a card application if the borrower already has a card from one of the company’s other brands. These rules often take precedence over the credit scoring.
3. Referrals to underwriters. If a scorecard is not allowed to make an automated decision or if a policy rule is triggered, then the application will be referred to an underwriter for a manual decision to be made.

These three cornerstones form the basis of the decision to accept or decline an application. Only after this decision has been made will the lender then select which product to offer and decide what is an appropriate credit limit. It is at this stage that income and salary will most often be taken into account. Normally the product selection and the assignment of a credit limit are based on combining the credit score with income and salary information. As a general rule, the better the credit score, then a higher proportion of your income/salary will be offered as a credit limit.

There are actually two types of credit score that a lender might use. An 'application' credit score is used when a new customer applies for a product and it is based on information from the application form and the CRA. A 'behavioural' credit score may be used when you already have products from a financial institution, in which case the lender can use performance and transaction on those products to assess how you are handling your existing credit facilities. Existing customers applying for new products can be subject to a hybrid score that uses both application and behavioural data and techniques.

What does a lender see as being 'good' and 'bad'?

To be blunt about it, a good customer is someone who makes the lender money and a bad customer is someone who does not. A customer is even worse, of course, if they cost the lender money. Identifying whether a new customer is going to be good or bad is actually very difficult, because the lender has no experience of the borrowers behaviour patterns. Given that they cannot assess the applicant’s performance directly, they have to do so by proxy and the best information that they have is whether the applicant has a good or bad payment history with other lenders.

For example, a lender may make the following distinction between a good and bad payment history.

Good: never in arrears or, at most, one payment in arrears over the period in question
Bad: two or more payments in arrears over the period in question.

A period would usually be between 6 months and 2 years, typically 12 months.

What Information is used in Credit Scoring?

As stated above, the vast majority of lenders decide for themselves how they will derive a credit score for an individual product. Some may use a score supplied by a CRA but this is very rare in the UK. The information that the lender uses for scoring comes from 3 places:

1. The application form
2. Information held by the CRA
3. Information held by the lender

Let’s look at what they use from each source and how they might perceive some of this information

The Application form

Information obtained from the application form will normally cover stability indicators and profile information. The longer you have been with your employer, bank and at your current address, then the more likely you will be perceived well by the lender. Typical examples of the information requested are:

• Time at Address
• Time at Bank
• Time with Employer
• Age
• Occupation type
• Residential status
• Marital Status
• Dependents

Information held by CRAs

CRAs obtain their data from the following Sources

• Credit Account Information Sharing (CAIS). This is the information that the banks and lenders share with each other.
• Public Information. This would include information on County Court Judgements (CCJs), Bankruptcies (sequestrations in Scotland) and Independent Voluntary Arrangements (IVAs).
• Credit Account Previous Searches (CAPS).
• Geo-demographic information. This is postcode-based information, but is not specifically about where the applicant lives. It is more an indication of the type of area. For example, they may use area profiling using techniques such as ACORN where each postcode area is allocated one of seventeen categories to described the type of area, spending patterns etc.
• Electoral Roll Information
• Your Financial Associates (i.e. the credit reports of those you are linked to through joint accounts or joint mortgages)
• CIFAS information. CIFAS is a non-profit association dedicated to the prevention of financial crime. It provides a range of fraud prevention services, including a fraud avoidance system used by the majority of the UK’s financial services companies. This system allows member organisations to exchange details of applications for products or services, which are considered to be fraudulent, because the information provided by the applicant fails verification checks.

Information held by the lender

Existing customer holdings

• Performance on said holdings
• Transactions and events on said holding
• Length, depth and type of customer relationship

What influences a credit score and how does this affect credit card users?

Any CCJs, defaults or missed payments will have a negative effect; therefore it is essential that card users operate their credit cards with great diligence.

• Any active credit accounts with significant balances recorded at the CRA will have a negative effect. There is a silver lining to this cloud for anyone who is paying off his/her debts. It means that your credit rating will get better and better as you reduce your credit balances.
• The number of active credit accounts in use will have a negative effect, so it is better to have just a few cards rather than many.
• In addition to the number of accounts in use, the lenders will also look at how much their credit limits have been utilised. A high level of utilisation may concern the lender.
• The type of neighbourhood you live in has an effect. This is not the specific neighbourhood that you live in, but is a classification of types of neighbourhood. You will be partly assessed based on what the performance of people in neighbourhood’s like yours has been. There is little that we can do about this factor.
• The number of searches and accounts opened in the last three to six months has an affect on your credit score. Try to minimise the number of credit searches that are done on your file: either one search per month for no more than 10 months of the year, or 2 or 3 applications within a month followed by none for 4 to 6 months seems to work for many.
• The number of accounts that are settled is a good sign, especially when the payment history has been faultless on them.
• The total balance on new cards i.e. the total balance on cards that have been opened in the last 12months.
• Having your status confirmed as being on the Electoral Roll at your current address is very important. The number of years on the roll at the address is also taken into account.

Some Common Questions

1. Is applying for a new credit card, once every six months, in order to take advantage of introductory low interest offers bad for my credit rating?

It is unlikely to affect your credit rating, providing you make your repayments on time. Switching cards every 6 months should not generate an abnormal amount of credit searches because searches are deleted after 12 months. Some people worry that lenders won’t want them as customers if they take advantage of special offers, but this is not true. Lenders get a fee each time a card is used: they don’t rely on the borrower paying interest

2. Can the number of credit cards I have affect my credit rating? I have taken advantage of 0% interest rates by shifting my balances from other cards. I now have 5 credit cards.

Swapping cards from time to time to take advantage of low interest or interest-free introductory offers shouldn't have an adverse affect on your creditworthiness. But you do need to make sure you do not apply for or have too many cards at once, you make your repayments on time and you do not let your level of borrowing get out of control.

Every time you apply for credit you will give the lender permission to search your credit report. Details of each search are kept on your report for up to two years (normally 12 months). An abnormal number of credit searches on your report might make a new lender worry that you have been the victim of fraud or that you have applied for an excessive amount of credit. As a result, you might get turned down. But switching one or two cards every six to nine months won't generate an abnormal number of searches.

When you apply for a new card, lenders will also look at your repayment history, how many cards you have already and how much available credit you have. This is because of the pressure on lenders to make responsible credit decisions and not just aim for profit. So, as well as making sure you make all your payments on time, it's important you close down any credit cards that you no longer use, otherwise new lenders might be unwilling to give you further credit. You should also bear in mind that a lender is unlikely to accept a new application from someone who already has one of its cards but does not use it.

Make sure you do not take on an unreasonable amount of debt. Although the cost of servicing credit is historically low just now, there is no guarantee that lenders will continue to offer these introductory deals. As a result, you need to consider how you would manage this debt if you had to start paying interest.

3. Do lenders look for rate-tarting patterns in people’s credit files?

The underwriter could well do, but systems generally would not.

4. What has the biggest effect on my credit score – having high available credit limits (some of which may be unused) or having existing credit limits maxed out? For example, how would a lender rate someone who has used £40,000 of credit out of £40,000 available (i.e.100%), versus someone who has used £40,000 of credit out of £60,000 available (i.e. the same debt, a higher available credit but lower percentage used)?

Experian Response: Determining what has the biggest effect on a person’s credit score is very difficult as it depends on the individual lender, whose scorecards and policies vary. What is increasingly important to lenders is the total level of borrowing in relation to affordability. There is now an increasing scrutiny among lenders over this issue, with Barclaycard and other lenders announcing plans to share behavioural data about credit card accounts in order to help spot people beginning to struggle - such as those paying only minimum payment over several cards. Therefore lenders primarily want customers who pay on time so they will look very closely at payment performance data above all else.

Insider’s Response: Lenders don't like either maxed out cards or lots of available credit, but all things being equal, I think the latter is better than the former. More importantly, though:

• £40,000 on a single card with a £60,000 limit is better than £40,000 on 10 cards with balances of £4,000 and card limits of £6,000
• £40,000 split equally over two cards with limits of £30,000 each is better than £40,000 on one card that has a £40,000 limit and nothing on a card that has a £20,000 limit.

2. Should I close my credit card when I no longer need it or will it improve my credit rating if I leave the card with a nil balance?

Experian Response: It is important that you close down any credit cards that you no longer use; otherwise new lenders might be unwilling to give you further credit. You should also bear in mind that a lender is unlikely to accept a new application from someone who already has one of its cards but does not use it. Closing unused credit cards is not only a credit score issue but also an important identity fraud one. People should close accounts they no longer use or else they can become easy prey for the identity fraudster.

Insider’s Response: Looking at it from a credit score point of view I would say that it is better to close a credit card after you have finished with it. For credit scoring, available credit is normally calculated on a card by card basis, not at an overall customer level, so there is little point having some cards maxed out and another one with a nil balance. Although the number of credit accounts open may have an impact, underwriters are more likely to consider the total available credit. On the other hand, you might get some good existing customer deals if the card is kept open.

What do I do next?

If you are interested in understanding what is on your credit file, why not get a free copy from one of the credit reference agencies. If you want to ask some questions about credit scoring, feel free to use our discussion forums.

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