Loan scoring is a quantitative process of determining the risk that a particular loan will default within a specific time frame. It involves the use of a statistical model that allows the lender to compare the characteristics of a proposed loan with a data set. The loan score is used in conjunction with an individual's credit score to help a lender decide whether to make a loan, what terms to set and when to sell the loan off to another party.
Lending money involves a risk that the borrower might default. The lender's primary business objective is to find a way to evaluate the risk of default upfront to avoid lending money in situations where there is a significant possibility it might not be repaid. This evaluative process also allows the lender to set loan terms based on the level of risk. Lenders charge a higher rate of interest on riskier loans to compensate for the increased possibility that the borrower might default.
Scoring is used by lenders as an unbiased method of determining creditworthiness. Borrowers and loans are scored so the lender can make a lending decision that compares the characteristics of the current scenario to other loans made in the past. A lender is free to use any statistical scoring model that exists or to come up with its own statistical model. Once the scoring criteria is applied to the transaction, the resulting score becomes part of the lending decision.
Consumers are typically most familiar with credit scores, but loan scores are equally important to the lender. Loan scoring takes into account things that are particular to the loan itself, rather than the borrower. For example, loan scoring for a mortgage could include the ratio of equity to debt on the property. This is important because it allows the lender to make a decision about the length of time to hold the loan as part of its own portfolio. At a certain point, a lender could sell the loan to a third party loan servicer, effectively removing the risk from its own holdings but at a loss of some of the interest the loan will pay in the future.
Lenders use loan scoring to set a cutoff score for making loans. Although borrowers with low-score scenarios might object to the impersonal nature of the process, scoring does allow for an objective standard that is supposed to put all borrowers on equal footing. Of course, certain types of lending decisions are not suitable for loan scoring. For example, special government loan guarantee programs that exist to spur lending to specific interest groups might render the need to use loan scoring moot because the government is backing the loans in case of default.