Credit Scoring and Credit Scoring and Scorecard Lending Scorecard Lending

Agribusiness FinanceAgribusiness Finance

LESE 306 Fall 2008LESE 306 Fall 2008

Credit ScoringCredit Scoring FundamentalsFundamentals

A credit score is a numerical expression based on a statistical analysis of a borrower’s credit history to represent his/her creditworthinesscreditworthiness, which is the likelihood that the borrower will pay his/her debts in a timely manner.

A credit score is primarily based on credit report information obtained from credit bureaus and credit reference agencies.

Credit ScoringCredit Scoring FundamentalsFundamentals

Lenders use credit scores to evaluate the potential riskpotential risk posed by lending money and to mitigate losses due to bad debt. Lenders also use credit scores to determine who qualifies for who qualifies for a loan, at what interest, and what credit limitsa loan, at what interest, and what credit limits.

Credit scoring is not limited to lending. Other organizations, such as mobile phone companies, insurance companies, and potential employerspotential employers are examples of other users of credit scoring.

Fundamentals Credit ScoringFundamentals Credit Scoring

A credit score is primarily based on credit report information typically from the three credit bureaus: Experian, TransUnion and Equifax.

There are differing approaches to calculating credit scores. The FICO is a credit score developed by Fair Issac & Company. It is used by many mortgage lenders that use a risk-based system to determine the possibility that the borrower may default on financial obligations to the lender.

Fundamentals of a Credit ReportFundamentals of a Credit Report1. Personal identifying information – your name,

address, social security number, birth date, current and previous employers.

2. Credit history – this includes your bill-paying history with banks, retail stores and others who have granted you credit. Information includes each account you have (when opened, type of account, how much credit it includes and amount used, your monthly payment. It will indicate when loan was paid off and if there were missed or late payments.

3. Public records – information that might indicate your creditworthiness, such as tax liens, court judgments and bankruptcies.

The FICO credit score is used by all three credit bureaus. It is used by over 90% of commercial banks when analyzing mortgage loan applications.

The FICO credit score is used by all three credit bureaus. It is used by over 90% of commercial banks when analyzing mortgage loan applications.

350 500 580 620 660 700 760 850

Loan automatically rejected below 500

Loan automatically rejected below 500

Loan automatically accepted above 500

Loan automatically accepted above 500

Credit Score Lending PracticeCredit Score Lending Practice

More information required. RiskPremium applied to interest rate.

More information required. RiskPremium applied to interest rate.

4.467 %risk premium

4.467 %risk premium

4.467 %risk premium

4.467 %risk premium

$930 difference in monthly loan payment!!!!

$930 difference in monthly loan payment!!!!

Scorecard LendingScorecard Lending

Credit StandardsCredit StandardsLenders use credit scores as a part of its

standards when evaluating loan applications.They will also establish standards related to

liquidity, solvency and debt repayment capacity (minimum current ratio of 1.50, maximum debt ratio of 0.50, minimum term debt and capital lease coverage ratio of 1.0).

Lenders also focus on the “Six C’s” of assessing a borrower’s creditworthiness.

Six C’s to Assessing CreditworthinessSix C’s to Assessing Creditworthiness

Hypothetical ScorecardHypothetical Scorecard

1. Credit score from credit bureau 15% ________2. Current ratio 15% ________3. Debt ratio 20% ________4. Debt coverage ratio 30% ________5. Other factors 10% ________

a. Continuing customerb. Primary commodityc. External control factorsTOTAL SCORE ________

Weight Met Standard

The lender then decides the minimum score for automatic approval, automatic rejection, and range over which additional conditions must be met (risk premium, additional collateral, compensating balances, etc.

Hypothetical ScorecardHypothetical Scorecard

1. Credit score from credit bureau 15% __12____2. Current ratio 15% __13____3. Debt ratio 20% __17____4. Debt coverage ratio 30% __25____5. Other factors 10% ___9____

a. Continuing customerb. Primary commodityc. External control factorsTOTAL SCORE __76____

Weight Met Standard

The lender then decides the minimum score for automatic approval, automatic rejection, and range over which additional conditions must be met (risk premium, additional collateral, compensating balances, etc.

0 51 55 60 65 70 75 76 100

Loan automatically rejected below 500

Loan automatically rejected below 500

Loan automatically accepted above 76

Loan automatically accepted above 76

Credit Score Lending SheetCredit Score Lending Sheet

More information required. Riskpremium applied to interest rate.

More information required. Riskpremium applied to interest rate.

50

Hypothetical Loan RatesHypothetical Loan RatesBase cost of funds 4.0%

Score > 75 6.0%

Score = 71 – 75 7.0%

Score = 66 – 70 7.5%

Score = 61 – 65 8.0%

Score = 56 – 60 8.5%

Score = 51 – 55 9.0%