Why Is Credit Scoring Used?

A credit score is a numerical representation of an individual's ability to manage financial credit in a responsible manner. The score also reflects the risk a financial institution may take if it extends additional credit in the form of a loan, a line of credit or a revolving credit account. Credit scores are tabulated based off a proprietary formula that can include total outstanding debt, age of credit accounts, type of accounts, number of late payments, recent credit inquiries and the severity of overdue payments. These credit scores are independently calculated by credit bureaus such as Experian, Equifax and Transunion.

Evaluate Credit Applications

Credit scores provide a quantitative method of denying or approving credit applications for financing products, homes, credit cards or loans. Lenders view the past history of dealing with credit as a good basis for knowing how someone will handle credit in the future. A high score indicates individuals with lower risk, a stronger record of on-time payments and lower credit utilization. Using a numerical score makes judging an application faster and less prone to human bias and errors.

Determination of Risk

Higher risk can translate to greater costs for businesses. Riskier individuals may be prone to not paying bills on time, performing riskier behavior, such as speeding or not being responsible with property. Businesses such as apartment complexes and insurance companies want to ensure they receive payments while minimizing the financial risk of offering coverage and services. These businesses use a credit score to determine whether to approve an individual's application based on the level of risk they are assuming.

Establishment of Rates

Businesses thrive on profit margins. If it costs more to provide services or products to an individual, it is in the best interest of a company to pass on part of the expense in the form of higher rates and prices. Modifying costs based on underlying expenses can help maintain a positive profit margin. Businesses such as insurance companies, lending institutions and even local utilities may use credit scoring to establish deposit requirements, interest rates, security deposits or coverage costs.

Employment

Some employers may use credit histories and credit scoring during the hiring process. Except in locations where prohibited by legal restrictions, companies may use a credit score to help evaluate a job candidate's trustworthiness, ability to handle responsibility and financial accountability. Credit scores may be used as an evaluation metric in some industries, such as finance, more than others.