The Scoring Game
"FICO" and Credit Scoring
If you're in the market for a loan, and especially for a home mortgage, you've probably heard the term "FICO Score" or "Credit Score" or even euphemisms like "strength of your application".
"Credit Scoring" is a means of applying a sophisticated mathematical model to your credit behavior, and the behavior of other borrowers like you. It's a way to more accurately gauge how great of a risk you represent to a lender.
Although there a dozens of scoring models being employed (and more on the way) the most well-known company in the scoring business is Fair, Isaac and Company.
A Model of You
Scoring models like the one developed by Fair, Isaac have always been shrouded in mystery, especially when it comes to specifics. Generally speaking, though, they utilize your credit history, income, outstanding debt and debt utilization over the years, access to credit, and other indicators of your financial behavior to determine how likely you are to pay your bills on time, or if at all.
A numerical score is then developed, typically ranging from 300 to 850, with the low end of the scale indicating a poor credit risk. This can tell a lender whether or not he'll lend to you. For example, a credit score of 620 is frequently cited as a "cutoff point" for loans which can be funded by Fannie Mae or Freddie Mac. Below that, and you're usually off into the private "sub-prime" market, where rates are higher, although Fannie and Freddie can do offer some 'credit improver' mortgages where FICO scores can be as low as 580.
What's in your FICO score?
According to Fair, Isaac, the breakdown of your FICO score is as follows:
- 35% of the score is determined by payment histories on your credit accounts, with recent history weighted a bit more heavily than the distant past;
- 30% is based upon the amount of debt you have outstanding with all creditors;
- 15% is produced on the basis of how long you've been a credit user (a longer history is better if you've always made timely payments);
- 10% is comprised of very recent history, based on your efforts to obtain loans or credit lines in the past few months;
- 10% is calculated from the mix of credit you hold, including installment loans (like car loans), leases, mortgages, credit cards, etc.
Other models being employed are sure to utilize these in various weightings, plus other data that may be fed in to the model. These might include your address or zip code, how often you've moved and other public and private information about you.
What It Means
So, now you've got a score. Why should you care? Increasingly, lenders are trying to fund loans with prices (rates, fees and terms) that more precisely match your risk. In theory, someone with a 850 score should get much better rates than someone with a 650 score.
So far, though, it hasn't exactly worked that way, at least not that precisely. There are several grades of credit which have arisen, most notably below the 620 line (A-, B, C, D). But above the 620 line, everyone pretty much pays the same. Lenders can penalize you for poorly managing credit, but don't much reward you for effectively and wisely managing your debt, at least so far.
Why Score At All?
It's not as though consumers have been clamoring for some sort of number, so why are we even bothering to go though this process for each loan? In the past, mortgages have been pooled together for sale, with these pools containing a range of credit risks -- all pretty good, but some better than others, and some worse than others. Some borrowers would be more likely to pay off their loans early, and others might fail to make timely payments at all. The securities derived from these pools each carried a vaguely known level of risk to the investor, which made holding and hedging these as a part of an investment portfolio a bit of a tricky business.
It's long been the desire of investors to be able to slice and dice portfolios of mortgage loans to add or remove risk (and rewards) to a larger investment portfolio. With known risk, a greater level of performance could be assured. Investors are willing to pay more for a greater level of precision, and began pressing the industry to adopt a means to achieve it. Hence, credit scores; now, a seller can put together a package of loans for sale that aren't from a wide muddy pool of credit risks, but rather from a very specific kind or kinds of borrowers, all with scores which are close together.
Who Really Benefits
Credit Scoring is actually a good idea, at least on paper, and some ways in practice, too. The sub-prime lending industry (for borrowers with not-so-good credit) could not have been developed without it. Certain borrowers have seen an explosion in the credit available to them, with more competitors vying for their business, lower rates and more choices in product. It's safe to say that thousands of homeowners have credit scoring to thank for their chance to get a mortgage. Credit Scoring is helping to make loan approvals faster, simpler and more convenient for all kinds of loans. At least so far, however, only folks at the bottom of the scale have seen significant "rewards" for the adoption of Credit Scoring on a wide basis in mortgage lending.
What's Bad About Scoring
In a word, secrecy. In the bad old days of mortgage lending, you may have been judged by a person or committee who used some subjective process to evaluate you, a process which may have been arbitrary. You didn't know what they wanted to see in a borrower, so you applied and hoped. Especially in the last 20 years, more and more light has been let into the underwriting process, and that knowledge turned into power for the consumer. Knowing where they stood in a lender's eyes, potential borrowers went from place to place in search of better deals, or could try to extract a better deal from the originator they chose.
Once pricing and underwriting were determined by credit scores, much of the leverage achieved by consumers was returned to the lender, and credit scoring became a high-tech way to draw a big, black curtain between borrower and lender. Since the score information could not be released to consumer (by contract in some cases), the power in pricing returned to the lender. Armed with a score, the lender knows precisely who you are... but you no longer had any idea exactly how good or bad you appear to him or her.
For some loans, lenders have stopped even providing rate quotes when you call. They want you to fill out an application first, so they can extract a score for you, knowing full well that once you've applied (and perhaps paid a fee) you're less likely to go elsewhere.
Today, although you can get a copy of your credit report at no cost once each year, accessing your credit score usually means you'll have to pay to do so.
Why All the Secrecy, Anyway?
It had long been a competitive stance by Fair, Isaac not to release scores and especially the components which influence a score. It's simple enough to understand that once that Fair, Isaac proved that scoring works, that other competing models would be developed. They are, including entries from the credit bureaus (see "New Scores on the Block" below) and Fannie Mae and Freddie Mac may score loans utilizing their own criteria, as well.
But there's a good reason why they have resisted telling consumers about their scores and what goes into them. All scoring models depend upon consumers going about their business as usual, paying or not paying bills on time, opening lines of credit and getting credit cards as they normally would. If you knew that closing out a Visa account you barely use might raise your score by some amount, you would close it. That change in behavior, repeated millions of times (and across the various kinds of credit weighting) would distort or destroy the model, rendering the score and scoring process worthless.
FICO has always maintained that revealing the score to a consumer would merely confuse them even further, and that the score by itself isn't useful without proper understanding of the process. To that end, they've developed a number of products you can pay for or subscribe to in order to discover or monitor your credit score, but they aren't free.
Scores Cause Overcharging?
Because you may not know how you appear to a lender, you might be charged far in excess of what you might otherwise pay. In this way, Credit Scoring may have helped foster "predatory lending", a situation where a borrower -- especially a less-sophisticated borrower -- may fall victim to an unscrupulous lender or broker. This can occur especially in cases where a borrower fails to shop far and wide for a loan, and happens largely in lesser-educated areas, and among the poor and elderly.
While the borrower might have pretty good credit, the salesperson might only offer them loans with high rates, fees, or both; not knowing that they might do far better elsewhere -- and lacking both the score information and understanding of the process -- the borrower signs on for the loan. If the borrower had access to his/her score and a little knowledge of the lending process, they could search more aggressively.
The secrecy which has surrounded credit scores is inherently anti-consumer. This situation seems to have improved over time but concerns about placing "good" borrowers into "bad credit" or more expensive loans are still with us, as are "predatory lending" allegations. These arguments are begun anew with each year's releasing of Home Mortgage Disclosure Act (HMDA) data. We simply believe that borrowers have the right to know how a potential lender sees them and have an opportunity to present themselves in the best manner possible.
New Scores on the Block
Fair, Isaac has been successful in making FICO scores the dominant tool in credit scoring, and have made a nice business for themselves selling credit scores to lenders and now consumers alike. It's little wonder then that new competition has arrived on the scene.
Aside from selling their own flavors of FICO scores (like "Beacon" from Equifax or "Empirica" from TransUnion, produced by running their proprietary credit report data through a FICO model) the three major credit bureaus have banded together to produce a joint venture called VantageScore LLC, where they merge certain of their credit report data to produce what is called a "VantageScore".
VantageScores differ somewhat than FICO scores, most notably that they use both a letter grade (A-F, like a report card) as well as a numeric scale ranging from 501-990. Introduced in March 2006, it's too soon to tell how serious a competitor to FICO the VantageScore will be, but you should expect to hear more about it as time rolls forward.
What's in your Vantage Score?
According to VantageScore, LLC the breakout of your Vantage score is as follows:
- 32% of the score is determined by payment histories on your credit accounts;
- 23% is based upon the amount of total credit available in all your accounts which you are currently utilizing;
- 15% is the portion of your score your outstanding balances contribute;
- 13% is determined by the "depth of credit" in your profile (the kinds of credit you hold and how long you've held them);
- 10% is calculated from the number of recent accounts you've opened, and how many credit inquiries have been generated from your search for those loans or lines of credit;
- 7% is the weight applied to the total dollar amount of credit you could potentially utilize.
At the moment, it appears that the only way for you to directly have access your Vantage Score is through Experian, one of the three major credit bureaus. At this writing, there was no information about cost anywhere on the Experian VantageScore website.
In the Future...?
At one point, enough pressure built around credit scoring that regulators and even legislators got into the act. Way back in 2000, Congress had even been considering the "Fair Credit Full Disclosure Act" (H.R. 2856), sponsored by Rep. Chris Cannon (R-Utah) which mandated the release of your credit score to you. California actually passed a law which requires that scores be made available to borrowers there. It was that that kind of pressure led Fair, Isaac to begin a program to allow consumers to have access to their credit score, so the federal bill was ultimately dropped. Perhaps a future Congress will pick up the baton and allow you to have an occasional free access to your credit score. Until then, at least you can buy access to your score from Fair, Isaac at http://www.myfico.com/.
In the meantime, if you are applying for a mortgage, you can certainly ask what your credit score is. FICO has stated that it has no specific objection to providing you with the number as part of a financial transaction.
MyFICO.com - Fair, Isaac & Company's consumer website.
http://www.creditscoring.com - An interesting account of one man's tirade against the credit scoring and disclosure process. Started in 1997 or thereabouts, Greg Fisher is still at it today.
http://www.annualcreditreport.com - The official site of the three credit bureaus where you can get your credit report once each year for free.
Copyright 2006, HSH® Associates. All rights reserved.
Contact us regarding reproduction of this article.