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What is 'Credit Scoring'

Credit scoring is a statistical analysis performed by lenders and financial institutions to access a person's creditworthiness. Lenders use credit scoring, among other things, to decide on whether to extend or deny credit. A person's credit score is a number between 300 and 850, 850 being the highest credit rating possible.

BREAKING DOWN 'Credit Scoring'

Fair Isaac Corporation's credit scoring system, known as a FICO score, is the most widely used credit scoring system in the financial industry. Lenders use credit scoring in risk-based pricing in which the terms of a loan, including the interest rate, offered to borrowers are based on the probability of repayment. In general, the better a person's credit score, the better the rate offered to the individual by the financial institution.

As a traditional approach to credit risk analysis, credit scoring is most effective for small owner-operated businesses and individuals. A similar concept, credit ratings, should not be confused with credit scoring. Credit ratings apply to companies, sovereigns, sub-sovereigns and those entities' securities, as well as asset-backed securities.

Limitations of Credit Scoring

Although credit scoring ranks a borrower's credit riskiness, it does not provide an estimate of a borrower's default probability. As an ordinal ranking, it only assesses a borrower's riskiness from highest to lowest. As such, credit scoring suffers from its inability to determine whether Borrower A is twice as risky as Borrower B.

Another interesting limit to credit scoring is its inability to explicitly factor in current economic conditions. For instance, if Borrower A has a credit score of 800 and the economy enters a recession, Borrower A's credit score would not adjust unless Borrower A's behavior of financial position changed.

More advanced methods of credit risk modeling include structural models and reduced form models.

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