Your credit score is a computer generated assessment of the risk of your loan application. In Australia it is specific to each lender, in other words your credit score will be different depending on which lender you apply with.
Your score will result either in your loan being approved, declined or referred to a credit officer for manual assessment.
So how does your credit score work? And how do lenders calculate it?
What information is used to calculate my score?
Your home loan application contains a huge amount of data that the lender can use to assess your application. The banks do not specifically publish the exact algorithms & information that their system uses to calculate your score, they prefer to keep this a secret to stop people “gaming” their system.
However many of our staff are ex-credit officers that have worked for a major lender and have an excellent understanding of how their systems work. As a general rule the following information will be used to calculate your score:
- Veda Advantage credit history: Banks will access your credit file with Veda Advantage. If you have applied for too many loans recently then you will have a high number of “enquiries” on your file. Any blemishes such as a default, court judgement or bankruptcy listing or having too many enquiries will have a significant negative impact on your credit score. Your credit history is the single most important factor used by lenders to calculate your credit score.
- Internal history: If you are an existing customer of a bank then their system will search all of your cheque accounts, savings accounts, credit cards, personal loans & home loans and will count the number of times you have overdrawn an account or been late with a payment. Having just one or two missed payments in the last 12 months is enough to result in your loan being declined. The good news is that banks cannot access the internal credit history that you have with other banks.
- Stability: The banks system will assess how long you have lived at your current address & how long you have been in your job for. People who have been less than six months in their job or at their current address will likely fail the banks credit score.
- Asset position: If you have a good income, but do not have any savings or assets then despite the fact that you can easily afford the loan, you are still likely to be declined. Your asset position must “make sense” when cross referenced with your income & your age. If you have saved a significant amount of money in a savings account then this will have a large positive effect on your credit score.
- Liabilities: Lenders are well aware that people with several unsecured debts such as credit cards & personal loans are a higher risk than people who have few debts. In particular, people who have more debts than they have in assets will almost certainly fail the banks scoring systems.
- Serviceability: If you can only just afford the debt then you are unlikely to be able to cope with the curve balls that life throws you from time to time. Lenders view people who can easily afford the loan as being a much lower risk. This is one of the most important aspect of your application and has a significant positive or negative impact on your score.
- LVR: The Loan to Value Ratio of your home loan is the percentage of the value of the property value or purchase price that you are borrowing. The lower the LVR, the lower the risk your loan is to the bank.
- Loan size: Larger loan sizes are typically a higher risk than smaller loan sizes. For this reason if you are borrowing over $1,000,000 then it will be more difficult to pass the lenders credit score. You will need to have a strong asset position, perfect credit history and good income to be able to get approved.
- Loan purpose: Different loan purposes each have their own risks. The most common loan purposes ranked from the lowest to the highest risk are: purchasing a home, purchasing an investment property, refinancing, business purposes, consolidating debt & undisclosed purposes.
Your credit history with Veda Advantage is without a doubt the single most important factor that the lenders use to calculate your credit score. In particular many people are not aware that applying for several loans or credit cards in a short period of time has a significant negative effect on their credit score. People who apply for several home loans at the one time are almost always declined, and wonder why they failed a lenders credit score.
Don’t try to “game” the lenders system by changing the information in your loan application. If their system identifies any inconsistencies between the information on your Veda Advantage credit file & your application then this will negatively affect your score or will result in your loan being declined.
Do you need help to get approved for your home loan? Our mortgage brokers are experts in credit scoring, and can help you to apply with a lender that does not credit score. Please enquire online and of of our brokers will contact you to go through your situation.
How do lenders create their algorithms?
The banks have spent years tinkering with their algorithms to make them as accurate as possible. There isn’t much point in credit scoring if it results in the good applications being declined and the bad ones being approved!
The way that banks work out which applications are a higher risk is that they monitor the performance of the loans that they have approved in the past. The larger banks have sophisticated tracking systems that can create reports on the percentage of particular loan types where the borrower is missing payments or where they have been forced to repossess the property.
Once they have identified types of loans where the delinquency rate has been high, they then get their risk department to analyse the results to work out why these loans have performed poorly. Often there are several factors at work & the interaction between them can be quite complex.
From this analysis the bank can create credit guidelines. For example they may decide that all mortgage applications to consolidate four or more debts is too high a risk and will be automatically declined. They may also decide that people consolidating two or three debts will have their credit score lowered. This means that if their income or asset position is strong the loan may still be approved, however if overall their position is weak then their application will fail the banks credit score and so will be declined.
If you would like to know the finer details of how credit scoring works then read on, if not then please skip to the next section!
Lenders aim to create a scorecard, which gives borrowers different number of points for different aspects of their application. They can also lose points for negative aspects such as a poor credit history. The final total of the points for an application is the credit score.
The actual statistical methods used to analyse the data in the lenders loan book are often non-linear probability modelling, random forests or CHAID. These mathematical methods of analysis identify links between specific data sets that are often unable to be identified by a person.
The credit score is just an arbitrary number, it is up to the lender to decide how much risk they are comfortable with. If a lender has a low cost of funds & is very aggressive in trying to gain additional market share then they may set up their scorecard in such a way that the score required to gain an approval is very low. At other times when funding is tight & the bank is not focusing on residential lending then they may move the cut off point up, declining more of the borderline applications.
Each lender has their own risk appetite which depends on their position in the market & their business model. They all carefully monitor the delinquency rates of their existing loan book and should they move outside of the acceptable range then they will tweak their credit score to compensate.
In actual practise most lenders do not use a simple scorecard, they instead use a system which “profiles” customers based on many aspects of their situation. If you appear to match profile that the bank believes is a high risk then your home loan will be declined.
The problems of credit scoring
The main problem of credit scoring is that the accuracy of the decision depends on the accuracy of the data. Banks are notorious for making mistakes, their systems are unreliable and have lots of problems with maintaining the integrity of the data that they hold.
The other main problem is that credit scoring is incredibly unpopular with customers, the bank staff & mortgage brokers. Customers feel that they have not been given a fair go. Often there are mitigating circumstances where an application that appears to be a high risk to the system is actually a low risk. A credit officer can pick this up right away, however in the harsh world of credit scoring there is no explanation sought from the customer or leniency given.
The history of credit scoring
Australian banks have in the past used experienced credit officers to make a decision on loan applications. It is only relatively recently that they have decided to use credit scoring as a method of assessment.
Originally credit scoring was used in the US & UK with excellent results. Our banks quickly adopted credit scoring for credit cards, personal loans and other small credit products where the cost of credit assessment is quite high in comparison to the profit from lending.
The Lenders Mortgage Insurers Genworth Financial & PMI (Which later was bought out by QBE) are both American companies, and were some of the first financial institutions to use this method of assessment for mortgages in Australia. From there our major banks began to introduce scoring for home loan applications.
There was significant criticism in the USA that their FICO scoring system was relied upon too heavily when approving loans and that this was a contributing factor to the sub-prime crisis. We believe the FICO score itself is quite accurate, and it was the lenders use of it that was the problem.
The unfortunate truth
As mortgage brokers, we don’t like seeing our customers applications assessed by a computer. However the unfortunate truth about credit scoring is that it is incredibly accurate at predicting how likely a customer is to default on their home loan. That is why lenders are hesitant to make an exception and override a decision made by their system.
The great news is that not every lender uses credit scoring! If you need help to apply with a lender whom can accept your situation based on its merits then please enquire online and one of our mortgage brokers will give you a call to discuss your options.