It’s the million-dollar question, how do credit card issuers use and interpret all of those credit scores they buy from the credit reporting agencies? Why am I approved with a good score and why am I declined with a poor score? And finally, why do they use credit scores at all?
The good news is that there’s actually answer to all of those questions. The bad news is you’re not going to get it from the credit card industry, which is why I’m here. Credit card issuers have used credit scoring to help them make lending decisions, for good credit and bad credit lending, for a shade over 20 years now. They’re used credit scores for almost twice as long as the mortgage industry, and their sophistication shows.
The answer to “why do they use credit scores” is the easiest to answer, so I’ll start there. They use credit scoring because it allows them to consistently approve, deny and/or assign terms based on a number rather than by a subjective review of a consumer’s credit report. Imagine the number of decisions a lender like American Express, Discover, or Capital One make on a daily basis. Can you imagine how inefficient their business would be if they all printed out the credit reports of their applicants, read them, passed them around the office, and then made a decision? So long instant credit!
Their decisions would also be inconsistent, which is dangerous for a lender. The last thing you want is to make an adverse lending decision for a consumer and then approve another consumer, who have identical credit reports. Using credit scoring eliminates that possibility because it’s all based on a score. If you score above X you’re approved. If you score below X you’re denied. Simple as pie.
You’re approved with a good credit score because a good indicates that you’re less likely to miss payments or default. That’s also why you typically get better interest rates with good credit scores. The reason you’re declined because of a poor credit score is because you’re more likely to default. And finally, the reason you pay higher interest rates with poor credit scores is because the lender has to be compensated for taking on a higher risk borrower.
So how are all of those pesky credit scores actually interpreted? What does FICO 750 mean, other than the fact that we know a 750 is better than a 700? The answer is quite simple, odds. That’s right, each of those scores has what’s referred to as an “odds to score” relationship. In English this means that each score level indicates the odds of you getting into credit trouble.
For example, and this is just an example, someone who has a score of 700 might get into credit trouble only 1 time out of 50, or 2% of the time. But someone who has a score of 600 might get into credit trouble 1 time out of 10, or 10% of the time. Sophisticated lenders understand the odds of your getting into credit trouble at any score level.
What lenders don’t know, and what nobody knows, is which 1 out of 10 (or 50) is going to be the one that defaults. That’s why everyone scoring poorly has to pay higher interest rates. The entire group pays the price of possibly being the one who is going to default. So the next time you find yourself getting angry at a lender who charges 29% interest on a credit card account remember that they’re not doing it to gouge the cardholder. They’re doing it so they CAN do business with that cardholder.
John Ulzheimer is the President of Consumer Education for Credit.com and owner of 2StepCredit.com. He is an expert on credit reporting, credit scoring, credit score ratings, and identity theft. Formerly of FICO and Equifax, John is the only recognized credit expert who actually comes from the credit industry. He is a weekly guest on FOX’s The Willis Report and is the credit blogger for the New York Times and Mint.com. He has served as a credit expert witness in more than 65 cases and has been qualified to testify in both Federal and State court on the topic of consumer credit.
