Table 1. Factors Affecting Your FICO Credit Score

Source: Credit Scores & Credit Reports. How the System Really Works, What You Can Do, by Evan Hendricks, 2005. Privacy Times, Inc.

Roughly speaking, companies that produce credit scores calculate them in several steps. In step one, they analyze data on each consumer, such as payment history, the amount owed at the moment, and other information like that listed in table 1, by plugging these data into a complicated and proprietary statistical model. The model predicts a consumer’s likelihood of becoming more than 90 days past due on a credit obligation within the next two years and produces an odds ratio for each individual. Odds ratios are the sum of a consumer’s good credit behaviors divided by the sum of his or her bad credit behaviors.

In step two, consumers are organized into groups (called “scorecards”) with others who have similar events in their credit histories. For example, if a person has missed a mortgage payment, his or her information enters a scorecard with other consumers who also missed a mortgage payment. Consumers with behaviors that are deemed most harmful to their creditworthiness enter a scorecard with a lowest range of credit scores assigned to it. Consumers who have the best behaviors and have paid all their bills on time enter a scorecard with the highest ranges of scores. All the consumers in between these extremes enter scorecards with score ranges in between, ranking from the worst to the best, that is, from the lowest to the highest. In this way, the ranking of scores in terms of consumers’ riskiness is always preserved.

In step three, the odds ratio is mapped to a credit score for each consumer, based on scorecard positions, to create the score-odds relationship. Lenders must have the entire relationship to make lending decisions, not just the scores but also the translation of those scores into odds ratios (what the scores mean in terms of the riskiness of potential borrowers).

It is important to note that the scores and the odds ratios are calculated at a certain point in time. Later, as information is updated, both can change. If individuals change their credit behavior, their likelihood of future default (the odds) will change as well. But whether and how a different odds ratio will affect a consumer’s score depends on the credit behavior of everyone else in the population, as it determines what scorecard those consumers enter.

The rank-ordering of consumers’ creditworthiness means that individuals with higher scores are anticipated to manage their debt better than those with lower scores. A score of 750 does not guarantee that individuals with that score will not default on their loans. It only means that they are less likely to default than, say, those with a score of 700. While rank-ordering is valid at any point in time a score is considered, scores should not be compared across different points in time. A score of 750 is always expected to perform better than a 700 calculated at the same time, but 750 today does not indicate the same level of riskiness as 750 two years ago.

It is also possible that the credit behavior of the entire population can change, so that the relationship between odds ratios and scores shifts (see figure 1). A shift downward, for example, would mean that the entire population has become riskier to lend to. This happened after the recent financial crisis, which resulted in increased credit risk for everybody. FICO Insights (2009) reports that mortgage loans originated in 2008 to consumers with scores of 700 were performing like loans originated in 2006 to consumers with scores of 670.