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What is Involved in Credit Risk Scoring?

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  • Written By: K. Kinsella
  • Edited By: Allegra J. Lingo
  • Last Modified Date: 24 July 2019
  • Copyright Protected:
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    Conjecture Corporation
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Credit risk scoring involves assessing the likelihood of a particular borrower defaulting on a loan, and then using a scoring system to attribute a credit score to that borrower that reflects that risk. Reporting agencies compile credit reports for consumers, business entities, and governments. Creditors obtain credit reports from credit bureaus before agreeing to issue new credit to prospective borrowers. Borrowers that pose a high credit risk must pay higher rates of interest than creditworthy borrowers.

Consumer credit bureaus examine a borrower's past credit history and current debt level during the credit risk scoring process. Credit reports for consumers use a numbered risk scoring system, within which people who are low credit risks have high scores, and people who are high risk borrowers are given low scores. Creditors provide credit reporting agencies with monthly reports that show the balances currently owed by borrowers, and whether debt payments were made on a timely basis. Excessive debt levels and frequent late payments cause an individual's score to fall. People who have had credit for many years and always pay their bills on time have the best credit scores, and people who have limited credit history or have filed bankruptcy have the lowest scores.

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Lenders use credit risk scoring when underwriting loan applications for businesses. The type of industry a business is in has an impact on its credit score because some businesses statistically have higher business failure rates than others. Some lenders do not write loans for businesses in certain industries because of historically high loan default rates. Businesses in industries that are key parts of the local economy usually receive high credit scores because, in the long-term, these businesses are the least likely to fail due to economic factors.

Agencies that perform credit risk scoring for businesses look at the size of a business, its annual sales, and its staffing model. Larger businesses are generally viewed as more stable than smaller businesses, but big businesses with low income and high costs are given low scores. The personal credit of a business owner also impacts a business loan if the lender requires the owner to sign for the loan as a personal guarantor.

Rating agencies use credit risk scoring to determine the likelihood of a government defaulting on its debt obligations. Bonds are a type of debt in which the bondholder is the creditor, and the government issuing the bond is the debtor. Governments that spend more revenue than taxes bring in receive low credit scores, as do governments that have previously defaulted on bond payments.

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