We hear about the importance of managing our credit scores quite often. And although we know the actions that can affect our score — late payments, defaults, frequent credit applications — some mystery surrounds the formulas that determine our scores.
Credit scorecards, the mathematical models that attempt to measure a person’s likelihood to display a positive or negative credit-related behaviors, take a few factors into account.
Data gathered from clients who have defaulted on loans are used to gauge the chances of others doing the same. Observations about customers who have a default history is compared to observations of those who have a clean credit history in order to calculate a number called a credit score.
Potential credit clients are assessed based on that historical data and placed in sets in order to compare their histories to past lenders’. A credit score ranks a client’s risk of default without explicitly identifying the probability of default.
Credit scoring techniques
There are a number of credit-scoring techniques, including Hazard Rate Models, Reduced Form Credit Models, Weight of Evidence Models, and Linear and Logistic Regression Models.
Some of these techniques are superior to others for the purpose of directly estimating a customer’s probability of default, but no single technique has been pinpointed as a superior way to predict default in all circumstances.
What it means for you
Many of the pieces that go into calculating your credit score are inherent (gender, age) and some are circumstantial (marital status, income, property rights). As your life and financial situation changes over time, your credit score baseline changes as well.
Until a definitive model for predicting default can be identified, the best way to increase your odds of keeping a high credit score is to be a married, middle-aged male with a high income and a clean credit history.
Since meeting all of those requirements might not be possible for you, improve your credit score by paying your bills on time and keeping your savings account as full as possible.
Check out these tips on how to improve your credit score.