This is the fourth installment of Fundastic's Business Credit Series and a deep dive into how credit scoring works. You should also check out our previous three articles: Why Business Credit Scores Matter for Your Business, How to Boost your Business Credit Scores and 5 Things Every Business Owner Should Know About Business Credit.
From the previous articles, you probably know that credit scores are widely used to underwrite for different business purposes including business loans, trade credit, vendor due diligence, etc. But how are the scores actually calculated? Here are the 4 nerdy things you should know about business credit scores:
1. Meaning of the Scores There are so many different credit scores including 4 major business credit scores (D&B, Experian, Equifax, and FICO SBSS) and 3 major personal credit scores (Experian, Equifax and Transunion). But all these scores represent a common theme: predicting the likelihood that you or your business will be paying the bills within 90 days after the due date. The higher the scores, the less likely you will be more than 90 days late on your bills. In fact, the Fair Isaac Corporation (FICO)'s primary business is building statistical models to predict this 90-day-late likelihood from the credit data. FICO looked at the users who defaulted vs. users who paid on time and identified the predictors that differentiate the two. FICO then used the predictors to build statistical models which can reasonably predict future likelihood of defaults using historical data and, from this, produced the FICO scores. It's like magic but these scores are highly correlated with future defaults, which is why FICO scores are widely used.
2. Calculation of the Scores Credit scores are not static. They are actually calculated in real-time. To calculate a score, you need two components: (1) the credit data, and (2) a scoring model. The credit data is pulled from the credit database (built by individual credit bureaus) based on the client's identity information. The scoring model is basically a function that takes the credit data as an input and outputs a score. The scoring model is built based on what we described in 1 (meaning of the scores). The interesting thing about the scores are that they change all the time because a client's credit data changes, and it can be scored with different versions of credit scoring models. It all depends on what credit data and which scoring model is being used at the point of time when the score is being computed. You don't have to be surprised if your FICO Experian score is 650 today and suddenly becomes 660 tomorrow.
3. FICO SBSS The FICO SBSS score is widely used by financial lenders as a disqualifier for business loans. For example, if you are getting an SBA loan, your FICO SBSS has to be at least 140. If your score is less than 140, it's still possible to get an SBA loan, but the loan may only be submitted as a standard 7(a) application or as an SBA Express Loan via E-Tran for a 50 percent guarantee if the lender is an Express Lender. So essentially, it could disqualify you or at least make it much harder to get. Most lenders aren't going to go through the trouble of submitting if they think you won't qualify.
It's very interesting how the FICO SBSS score is calculated. SBSS model can support up to two consumer bureau data sets and up to three business bureau data sets. It can be programmed to automatically rollover from one business bureau data set to another, in whatever order of priority the lender prefers. So if the lender wants Experian business as the default, the SBSS pulls in the Experian data set. If it isn't a deep enough report, it knows to automatically rollover to your second preference, say D&B. If the D&B data set still isn't deep enough per the lender's requirements, it will rollover to pull in Equifax business. If there's not enough business credit data available, it will just use the personal credit data to calculate the SBSS score. In other words, there can be many different versions of SBSS scores depending on how the lender implements the SBSS model. It is possible that your SBSS score passes for one lender while fails for another. In that case, you might want to check your credit reports to make sure there're no errors because that discrepancy shouldn't happen too often unless there's some data issues.
4. FICO Model Upgrades You might have heard that the latest FICO model will weigh less on medical debt. If your credit scores have been affected by medical collections, I am sorry to tell you that this positive change won't be in effect widely for a little while. If you go to myFICO.com and check your scores, you will get the scores from the latest model. But most lenders and credit underwriters most likely are still using the older versions. They need to do a credit system upgrade to deploy the new FICO model. Some of them are probably still running really old versions (like 5+ years old) because the upgrade costs money and occasionally requires a system overhaul. It's like an iOS upgrade but a lot more involved. The new upgrades on the credit scoring models take time to reach wide adoption.
OK. That's a lot of nerdy information. I hope this helps you understand how credit scoring works. If there's something odd happening with your credit scores, you can come up with the reasons and see if you can find a workaround. In general, this article is for the curious minds who want to know how credit scoring works. You should also check out our previous three articles.