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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.

What's in your 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 a better deal.

Credit Scoring is a high-tech way to draw a big, black curtain between borrower and underwriter. Since the score data could not be released to consumer, by both choice and contract, the power in pricing returned to the lender. Armed with a score, the lender knows precisely who you are... but you no longer have any idea exactly how good or bad you appear.

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.

Why All the Secrecy, Anyway?

It's been a competitive stance by Fair, Isaac not to release scores. 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, 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. The scoring model depends 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 claimed that revealing the score to a consumer would merely confuse the borrower even further, and that the score by itself isn't useful without proper understanding of the process.

Scores Cause Overcharging?

Because you can't know how you appear, you might be charged far in excess of what you might pay. Credit Scoring may have helped foster "predatory lending", a situation where a borrower -- especially less sophisticated borrowers -- 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 surrounding credit scores is inherently anti-consumer.

What's Coming

Enough pressure has been building around this issue that regulators and even legislators are getting into the act. Recent, Congress has been considering the Fair Credit Full Disclosure Act (H.R. 2856), sponsored by Rep. Chris Cannon (R-Utah), but no action has yet been take to advance the bill along. The California legislature is also considering a law to force release of credit scores. Soon, FICO and the credit reporting agencies TransUnion, EquiFax and Experian are planning to provide evaluations of your credit profile to you... for a fee.

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.

Related resources:

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.

Copyright 2002, HSH Associates. This article may be copied and distributed, providing that full source credit is left intact and a link to (or mention of) our Web site is included (in text form, if applicable).

HSH Associates, Financial Publishers
1200 Route 23
Butler, NJ 07405
800-873-2837 | 973-838-3330

 

 

 

 

 

 

 

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