Lending to individuals and businesses continues to be a risky endeavour.
More so in a market where credit providers and financial intermediaries such as banks have limited exposure to advanced credit management tools and ready credit information or analytics.
In addition, prospective credit clients such as Small to Medium Enterprises and the informal sector have been driving economic activity yet the SMEs and informally employed individuals hardly maintain proper financial records.
This makes it even more complicated when trying to assess their credit worthiness. Credit granting has therefore proved to be time consuming, with the information asymmetries and processing requirements increasing the costs even towards good quality borrowers.
Loans granted have ended up representing subjective biases rather than a systematic evaluation of risk.
Notwithstanding the challenges, the market is starting to embrace the use of credit scoring and analytics.
There is a growing realisation, particularly among early adapters with dynamic management, that the process of credit scoring and the use of credit bureau scores, serves to enhance the credit analysis process and effectively evaluate risks associated with different categories of borrowers.
The process uses statistically validated criteria that are objective and independent. As a result, credit risk is better managed and efficiency is enhanced.
The credit granting process becomes streamlined with processing taking a matter of minutes where it could have taken up to weeks or even months in certain instances. Ultimately a reduction in loan processing costs to the lender contributes to a lower cost of credit to the benefit of consumers and businesses.
This article seeks to unravel the subject of credit scores, particularly credit bureau scores as they relate to individual borrowers.
A credit score is simply a numerical expression based on a statistical analysis of a person’s credit files, to represent the credit worthiness of that person.
The actual score is a number within a range typically between 100-1 000 with 100 being the poorest score and 1 000 representing an individual with the highest possible credit rating.
In other words, the higher your credit score the better for you as it translates to higher credit worthiness.
This gives rise to the distinction between prime and sub-prime credit. It therefore is important for the market to understand what goes into the credit bureau score and individuals can be mindful of the multiple factors that will have a bearing on their credit score.
This is an important starting point towards encouraging a culture of responsible borrowing and credit activity.
With the emergence of more advanced credit risk management tools by our credit reference bureau, the local market has moved towards the use of a bureau score by credit providers and financial intermediaries.
Institutions will soon incorporate bureau scores in their credit granting criteria and loan pricing and this is done in a variety of ways.
A credit provider will apply variable interest rates and differing loan charges corresponding with predetermined bureau score categories.
This enables good quality borrowers with higher scores to benefit from less onerous requirements, lower or even no down-payment requirements as well as favourable rates. The cut-off scores will be determined based on the company’s risk appetite and profitability per account, as illustrated in the accompanying table.
The table illustrates the potential profit and loss from customers within each score band.
Each customer who is granted a loan will make purchases resulting in a profit to the business.
Generally, customers with higher scores will make larger purchases, and result in higher profits.
The main factors that go into determining an individual’s credit bureau score are summarised into five categories listed below in order its importance. Each ingredient carries a different weight depending on its relevance:
Length of credit history;
Types of credit.
Payment history is the most important determinant of credit scores. It includes an individual’s performance in account payments, the existence of default judgments or bankruptcy, overdue payments, amount past due, and the time since any adverse occurrences.
Amounts owed include those on accounts individually and totalled together as a whole. This looks at the level of indebtedness of an individual.
It can be reasoned that past some point, more debt will lower the score by raising questions about the repayment ability of a borrower.
Conversely, not having debt means that the subject cannot demonstrate a good payment history.
The length of credit history looks at the time a consumer has had active accounts and long running accounts generally indicate stability in credit relationships, whereas new ones might indicate financial distress especially if there are many of them.
Factors that are excluded from determining a credit bureau score include your race, religion or national origin.
Consumers can typically keep their credit scores high by maintaining a long history of always paying their bills on time and not having too much debt.
XDS Credit Bureau provides credit risk management solutions and specialised credit management analytics.
The company collects and processes credit data to generate the scores that are used by credit providers. In addition, the bureau data is one of the main external sources that banks can use for calculating and validating their internal risk management outputs.
Over time, larger financial institutions will use scores as inputs into their internal models while smaller institutions will prefer to directly use credit bureau generic models.
Banks will have periodic cycles of model validation that includes monitoring of model performance and stability; review of model relationships; and testing of model outputs. Therefore, banks can use XDS bureau models for benchmarking and demonstrating the quality of their own models.
XDS combines strong business practices, information technology skills and experience that enables us to provide consumer, business and personal solutions that significantly contribute to sound and informed credit decisions for our clients.
Farayi Dyirakumunda is a director at XDS Zimbabwe, a credit reference bureau and risk management company. He can be contacted on [email protected] / www.xds.co.zw