A look inside the credit score cocktail

The Red Tape Chronicles recently attempted to explain what goes into the secret formula that determines a borrower’s credit score, the secret formula that determines what consumers pay for loans, credit cards, and even car insurance.

Credit scores are important to every consumer’s financial well-being. For example, a consumer with a FICO score of 619 will pay twice the interest rate as a borrower with a score of 720. On a $500,000 mortgage, this could add up to about $750,000 more over the life of the loan.

But credit scores (or the article) do not entirely make sense. For example, according to the article, “[c]redit scores essentially distill all the information from a credit report into a single number in an attempt to quantify the odds borrowers will repay loans on time.”

Several paragraphs down, however, it says that “[c]redit scores . . . take no account of a consumer’s job or income–something lenders call “capacity” to pay.”

In other words, credit scores have absolutely nothing to do with a borrower’s ability to repay loans on time, only whether a borrower is likely to do it anyway. Lenders are supposed to supplement a credit score with some information about income, but not all do, which may account for some of the bad decisions leading up to the subprime meltdown.

[photo: Fair Isaac Corporation]