Whether you’re eyeing a new car or ready to buy your first house, your credit score is a key factor lenders consider. But is this the best way to determine eligibility for financing? We interviewed William Mahnic, an associate professor at Case Western Reserve University, about the connection between credit scores and loans.

Q & A with William Mahnic

Q. Are credit scores a good way to measure the risk factor associated with loan applicants? Why or why not?

A. Credit scores are the best method we currently have to assess a loan applicant’s likelihood to repay a loan for three reasons. First, the algorithms behind the determination of a credit score have been historically successful at predicting the likelihood of a borrower repaying a loan. Second, it is a cheap and easy way for lenders to quickly screen loan applicants. This keeps the cost of lending low, and consequently, the cost of borrowing. Third, the credit score model is not vulnerable to cultural or economic biases. Its only focus is on the numbers entered into the model.
Q. Do you think eventually (with the increase of consumer data) we will have a more personalized way to create risk models and credit scores? Could you predict what that would look like?

A. The FICO model has been very successful in predicting borrowers’ behavior. Accordingly, I do not believe that the lending community will abandon it in the near future. Why fix something that is not broken?

Rather than seeing established, mainline lenders change, what may happen is that certain niche lenders may arise to serve the borrowing community that has poor or non-existent FICO scores. We are already seeing this in peer-to-peer lending websites.
Q. Are there any other factors that should be considered in a credit score that aren’t currently used and that could provide a better evaluation of potential borrowers?

A. I believe that any attempt to enter judgment calls into the credit score calculation could lead to bias against certain lending groups and to weakening of the credit score’s ability to predict loan default. Judgment calls would include current income, accumulated assets, and level of education.

William Mahnic is an associate professor of banking and finance at the Case Western Reserve University Weatherhead School of Management.