New Credit Score Could Help Millions, Eventually

The plea for credit score help was direct, almost desperate. A woman and her husband placed a “fairly large” good faith deposit on a home. But then her credit score fell from 626 to 619, just one point shy of the minimum required by the Department of Veterans Affairs to qualify for a mortgage.

She already had called to remove two old collections reports from her credit file, but that failed to give her the boost she needed. Now the couple was in a bind. If they failed to boost her credit score in the coming week, they would lose not just the chance to buy the house, but their cash as well.

“HELP PLEASE!” the woman, under the username “Butterflieson,” posted on a web forum run by FICO, the company that creates the credit scoring model. “Is it possible to raise score 1 point in a few days?”

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A Step Forward, Delayed

Millions of Americans have solidly good credit; millions more are stuck with seriously low scores. But there are also millions of consumers in the middle—people with scores that straddle traditional dividing lines between “good” and “bad.” A rise or fall of just a few points could save or cost them thousands of dollars in extra interest payments.

It could even change their ability to buy a house or get a credit card.

“If a consumer is applying for a mortgage and they tend to have higher utilization rates on their credit cards, it could (raise their credit score and) make a difference” in how much they pay for interest, says Tom Quinn, Credit.com’s credit scoring expert and formerly the vice president of scoring at FICO.

Especially for people caught in the middle, a recent update of the FICO credit scoring model, called FICO 8, could mean big changes. Depending on the type of credit problems consumers have in their past, some people may receive slightly higher credit scores, which could make it easier to buy a house or get a credit card. For other consumers, the changes will hurt their scores, making it somewhat harder to get credit.

“For individual consumers, it depends,” Quinn says. “For some consumers, their FICO 8 score will be higher than their previous score, some consumers’ [score] will be lower, and others won’t change at all.”

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The Basics I: Who is Fair Isaac?

If you don’t understand what FICO is and how it works, don’t feel bad. The credit scoring system almost seems designed to be inscrutable to the average person. FICO started life in 1956 as Fair, Isaac and Company, founded by engineer Bill Fair and mathematician Earl Isaac to help department stores and gas station chains decide when to extend in-house credit cards to customers.

Even as the basic scoring model has evolved, the basics have remained essentially the same. A credit score is a number assigned to each consumer that attempts to summarize whether that person is worthy of receiving credit. Mortgage lenders, credit card issuers, car dealers and other businesses that extend credit rely on credit scores to decide whether to extend credit—and if so, how much to charge in the form of interest.

While many companies offer different scores, the FICO score has emerged as the benchmark. And FICO itself offers many different types of scores that are customized for different types of loans, including separate scoring models for mortgages, auto loans and even insurance. But they all use similar types of information, including a consumer’s history of paying her debts on time, how much of her available credit she actually uses, how many different types of credit she uses, and whether she has any history of unpaid debts. And they all perform the same general function: To use a consumer’s credit history to try and predict whether she will pay her debts in the future.

[Resource: Get your free Credit Report Card]

FICO scores summarize this prediction in a three-digit score that ranges from 300 to 850. People with lower scores are considered higher risks that they won’t repay their debts; people with high scores are considered low-risk.

For decades, FICO kept a relatively low profile. Then in 1995, Fannie Mae and Freddie Mac, the government-sponsored giants that form the backbone of the mortgage industry, decided to start using the FICO score in their computer programs to help decide which consumers qualify for mortgages bought and sold by the companies.

“That’s really when it took off,” says Evan Hendricks, founder of PrivacyTimes.com, who has testified before Congress on credit scoring issues.

Next came the housing boom. As many banks loosened their lending requirements, they drastically cut back on their own internal underwriting departments, relying more and more on the FICO score to determine whether a consumer was worthy of credit. Soon FICO was marketing its score to everyone from health insurers to casinos, Business Week reported, advertising it as a low-cost way for companies in a broad array of markets to decide who gets credit and who doesn’t.

Which is how a company that most people have never heard of, and even fewer understand, came to play such a pivotal role in the day-to-day functioning of the modern economy.

“FICO is the wizard behind the curtain of the economy,” Matt Fellowes, a scholar at the Brookings Institution, told Business Week. (Fellowes did not respond to calls and emails seeking comment.)

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The Basics II: OK, What’s in that Special Sauce? »

Image: D Sharon Pruitt, via Flickr.com

The Basics II: OK, What’s in that Special Sauce?

To arrive at a consumer’s credit score, FICO considers a number of different factors, including how many different kinds of credit accounts a consumer has, how much of her available credit the consumer tends to use, and whether the consumer makes her payments on time.

FICO updates its scoring model every two or three years, much like Microsoft periodically releases new versions of software, Quinn says. It makes the updates partly to take advantage of new kinds of data, and also to react to changing consumer behavior.

For example, many consumers drastically reduced their credit card debt after the financial crash of 2008. In the face of such a broad behavioral change, the model must change too, since what may have been a low credit utilization rate in 2006 might have been simply average by 2009.

“Over time, degradation can occur to any scoring model,” says Clifford O’Neal, spokesman for TransUnion, one of the three national credit bureaus.

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The newest version of the scoring model is more precise because it considers more types of consumers. For example, some people have little in the way of credit histories. Comparing those people to all consumers as a whole would leave them with low credit scores, even though many people with little credit history make perfectly fine credit risks. The same goes for people with unpaid bills in their past. In some cases that may mean three unpaid mortgage payments, which could mean the person is a bad credit risk now. Another person’s unpaid bills might be for small medical expenses that she never learned about.

By dividing people with similar credit histories into different groups, and comparing them against people in those groups, FICO is able to give more accurate predictions of consumers’ willingness and ability to pay.

“If you were to build just one scorecard on the whole population, people with previous delinquency would all plummet to the lowest part of the score range because compared to most other people, they look really risky,” says Quinn. “But if you build a score card based just on delinquencies, someone with lots of delinquent payments now is riskier than someone with one late payment six years ago. So it helps you find people with less risk.”

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Whereas the previous model divided consumers into 10 different categories, the new one uses 16. That should help lenders more fine-tuned decisions, according to FICO.

“With FICO 8 Score, FICO scientists were allowed for the first time to break the blueprint of our original FICO scoring algorithm,” Jason Sprenger, a FICO spokesman, told Credit.com in an emailed statement. That creates “a segmentation that rendered significantly more predictive credit scores than was possible before.”

Compared to previous versions, FICO 8 goes easier on people who have missed payments on small debts under $100, which often include medical debts. The Commonwealth Fund estimates that 14 million Americans struggle with medical debts that they believe are erroneous, the Wall Street Journal reports, and the Federal Reserve estimates that half of all debts in collection arise form medical bills.

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That means the new FICO scoring model could help millions of consumers improve their credit scores and reduce the amount of money they pay in interest.

“One of the good things in 8 is that debts under $100 are not going to have the same impact,” says Hendricks. “I think it’s safe to say a majority of those are medical debts.”

On the other hand, FICO 8 considers people with high credit utilization rates to be somewhat higher credit risks than previous versions. That may hurt the credit scores of people who use relatively high levels of their available Credit. “So if you carry high balances, you’re probably going to lose a little more points the before,” Quinn says.

The two tendencies may cancel each other out, Quinn says. Banks probably won’t become any more loose with credit under the new model, and they probably won’t lend to more people. Instead, lenders will subtly shift their definitions of which consumers qualify for which products.

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Reading Tea Leaves »

Reading Tea Leaves

Most people haven’t noticed any difference at all from FICO 8, and it’s not because their credit histories are impervious to the changes. Rather, major lenders have been unusually slow to switch to the new scoring model.

In fact, the model was originally called FICO 08 because the company planned to implement it in 2008. The new scoring model is named for 2008, when it was supposed to be released. (Because of a lawsuit FICO brought against the Equifax credit bureau, the release was delayed until early 2009.) Now that it’s going on four years since the original release date, FICO simply dropped the zero. Three years after the actual release, most major lenders still have yet to adopt it. And FICO 8 is entirely absent in the mortgage market.

But good luck getting confirmation of that fact from FICO, the credit bureaus or any major lenders, which use consumer data to make the scores but largely refuse to tell the public what they do with it.

“There’s no publicly available data on it,” says Hendricks. “But that’s my sense of it, that it has been slower.”

[Credit Score Q&A: Length of Credit History vs. Late Payment History]

Figuring out exactly what’s happening with FICO 8 is an exercise akin to reading tea leaves. Try calling FICO to ask how implementation of FICO 8 is going, and they say you should call the credit bureaus. Call the bureaus, and they refer you to the banks. Call the banks and they refuse to talk, saying their scoring models are proprietary.

The upshot: This is an industry that relies on data supplied by consumers to function, and that dictates the finances of millions of people. And yet it arguably operates with almost zero accountability to consumers.

“It’s not as transparent as it needs to be,” Hendricks says. “All this information should be filed publicly so we know what’s going on. But we don’t.”

So how can we tell that implementation of FICO 8 is going slowly? After all, FICO issued a press release in June trumpeting the fact that Citibank had implemented the new model.

“The results of Citi Cards’ testing and its adoption of the FICO 8 Score highlight the business value that FICO creates and delivers for its clients and their customers,” Greg Pelling, FICO’s vice president of scores and analytics, said in the release.

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This is one of those cases where what’s said is less important than what’s left unsaid, however. By trumpeting Citi’s adoption of FICO 8 likely made a tacit admission that no other big bank—Chase, Wells Fargo or Bank of America—has made the switch. Together these four companies dominate the credit card market, and control sizable chunks of many other lending industries, including consumer loans.

“It’s an 80/20 rule, where the top 10 institutions in the U.S. represent the vast majority of credit checks each year,” says Quinn.

At least one other major bank plans to switch to the new model, but the details are vague.

“We’re in the process of implementing it, but I wouldn’t have any more details to share,” Betty Riess, a spokeswoman for Bank of America, told Credit.com in an email.

Then there’s the fact that FICO 8 is absent from the entire mortgage industry. Fannie Mae and Freddie Mac, the two government-sponsored entities (GSEs) that currently buy, sell or insure virtually every mortgage currently written, so far have stuck to older FICO models. Mostly they use different versions of FICO Classic, which was last updated eight years ago, according to information from FICO.

“(W)e work with the GSEs to support the adoption of FICO 8 as the industry standard score,” Sprenger says.

[Resource: How to Build Credit if You Are New to the United States]

Why So Slow? »

Why So Slow?

If FICO 8 can help millions of people with small delinquencies improve their credit and help lenders make better decisions, why hasn’t it been implemented yet? A lot of it has to do with the complexity of modern banking, Quinn says. Just pick up one of the hundreds of credit card offers you receive in the mail every year. Before mailing you that envelope, the bank had to decide what type of borrowers it hoped to attract, how many of them were likely to respond, what ratio of those would actually qualify, how much they could be expected to borrow, and how much all of that would bring the bank in terms of costs and profits.

The assumption underlying all those decisions is how to determine a consumer’s creditworthiness. Change that assumption, and everything else has to change, too.

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Before banks can change to a new credit scoring model, “they have to get sign-off from compliance, finance, marketing, treasury legal” and other internal departments, Quinn says. “It’s a question of how it affects their business.”

Put another way, big ships don’t spin on a dime.

“We are pleased with the progress achieved to date, particularly since it often takes a lender more than a year to validate and implement a new score version simply due to the number of steps and magnitude of the work involved,” Sprenger says.

Then there’s the little issue that the world economy was shaken to its knees in 2008, and the recovery since then has been slow and unsteady.

And in the mortgage market the two dominant players, Fannie and Freddie, both went bankrupt since FICO 8 was introduced. Now they’re fighting for their lives, since many Republicans and some Democrats in Congress believe both companies should be liquidated.

It’s understandable that adapting to a new credit scoring model isn’t exactly the top item on Fannie and Freddie’s “to do” lists.

“Fannie and Freddie have had a pretty rough road lately, much of it their own making, so they have a lot of house to clean up before they get to new scoring models,” Hendricks says.

Besides, many lenders may simply feel that if the scoring model isn’t broken, don’t fix it.

“The focus on evaluating a new FICO score became lower because they had other priorities, and the FICO score they had works,” Quinn says.

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What Happens Next?

Even though implementation of FICO 8 appears to be going slowly, more lenders continue to adopt it, the company says.

“Many more are in the process of adopting the score or are completing their evaluation,” says Sprenger.

Perhaps the biggest step forward for the new score would be Fannie and Freddie accepting it as their own. That may still happen, but the process is slowed by more immediate problems in the mortgage industry, Sprenger acknowledges.

“(T)hey’re in the process of looking at it among the other priorities they have on their plate,” Sprenger says.

And even after most major lenders have implemented FICO 8, most consumers won’t notice many big changes in their scores. Some people will receive a small boost when small delinquencies are deemphasized. But other factors, including on-time payments and keeping credit card balances low, will go a lot farther toward improving consumers’ credit scores than waiting for FICO 8 to become the new standard.

That may be true even in the mortgage market, which has suffered so much since the housing bubble burst.

“I’m not sure FICO 8 would change mortgages that much,” Hendricks says.

In the meantime, it’s not as though consumers are hurt much by the continued use of older models. As Sprenger says, “Prior versions of the FICO Score remain in use today because they are proven to remain highly predictive over time.”

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