How Well Do Credit Scores Work?

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How’s that for a loaded question?  Credit scoring is one of the most criticized processes in the financial services world.  In fact, many people blame reliance on credit scores, in part, for the credit meltdown.  So the million dollar questions are: Do these things actually work and how well?

Why They Work

Credit scores are designed to do one thing and one thing only – rank order consumers based on their level of risk to a borrower.  If 100 people walked into a bank and all of them applied for an auto loan the bank could simply pull their credit reports and scores and shuffle the applications from the highest score to the lowest.  The folks who scored higher are generally going to perform better than the folks who scored lower.

This is, of course, not a perfect system.  There are going to be consumers who have FICO scores in the 800s who default and consumers who have scores in the 500s who pay future obligations on time.  But, the number of defaults coming out of the 800s is going to be a small fraction of the number coming out of the 500s.

Further, credit scoring is most effective when it’s applied to a large number of consumers, or “observations.”  This is a statistical process, and the results are going to be more understandable and acceptable when you look a sample of 200 million plus consumers’ credit scores, rather than a sample of one consumer who doesn’t agree with his or her score.

Credit scores definitely work.  How do I know? If they didn’t work, banks couldn’t use them to make decisions.  In order for a bank to legally use a credit score it has to meet two criteria:  First, the score must be based on a model that is statistically derived.  Second, the performance of the scoring system must be demonstrably sound.  Focus on the second requirement, as it’s the one that ensures that banks are using scores that do, in fact, distinguish between the risky and not so risky.

Why Some People Don’t Like Them

Credit scores have also been heavily criticized for the mortgage meltdown.  But, did you know that some mortgage lenders were ignoring low scores and approving mortgage loans regardless?  There were many examples of large lenders systemically approving loans for consumers with scores below 500.

There’s an old episode of the Simpsons where Homer wants to buy an RV because his neighbor, Ned Flanders, bought one.  Homer goes to a dealership and has the salesman pull his credit report.  A red light and bells and whistles start going off.  When asked, “Is that good?” the salesman replies, “no Homer, that means if I give you a loan I might go out of business.”  Well, a lot of mortgage lenders were ignoring the red lights and ended up going out of business as a result.

Now, how well credit scores work is certainly up for interpretation.  Technically, as long as a scoring system properly ranks a poor risk group below a lower risk group, it’s working.  But, that certainly doesn’t mean it’s working well.  There are a variety of statistical measurements that are used to determine how well credit scoring systems are working.  In my 20 years, I’ve never seen an example of a general-use scoring system, like FICO, fail any of the various performance tests.

It’s my opinion that much of the credit score dissent is coming from a small, but vocal, population of consumers who feel they’ve been cheated or otherwise disrespected by credit scores.  There are also some that simply don’t trust credit bureaus, banks, FICO or anyone else associated with financial services organizations.

According to new data just released by FICO, about 35% of consumers have FICO scores below 650.  But would you believe that about 38% have FICO scores above 750?  That’s not a good score – that’s an elite score.  You don’t hear much complaining from that 38%.  They generally believe credit scores work just fine.

There’s also a group of consumers who believe credit scores are designed to keep us in debt or otherwise act as an incentive to get into debt.  Really, all you have to do is spend about 20 minutes doing research about credit scores and you’ll find that you can have killer credit scores without a penny of debt.  In fact, the 38% of consumers who are above 750 are there because they have little or no debt.

Still others lash out because they either don’t understand how credit scoring works, or they don’t believe it works as they’d like to see it work.  This is a common cry from the “Do you know how much I make?” crowd.  Don’t get me wrong, I would agree 100% that credit scores are complicated and that how they work doesn’t always jive with common sense.  But, that certainly doesn’t mean they’re not effective and they don’t work.  Keep this in mind before you criticize them.

John Ulzheimer is the President of Consumer Education at, the credit blogger, and a contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of or Intuit. Follow John on Twitter.

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