Friday, April 19, 2013

A History of FICO Scores Part II

In the 1950’s, someone asked the question, how can we judge someone’s credit without having to read the entire credit report?

You see, not only was time an issue, reading the reports and making judgments based on the information in them became an issue. You could have two loan underwriters look at the exact same loan package and come up with wildly different opinions on a person’s credit. Some would give their approval of the loan and others denied the credit. There was no set of rules that told underwriters how to decipher and utilize the information they were gleaning from credit reports. It was all just “someone’s opinion,” very subjective.

Thousands of new borrowers were being approved daily and lenders needed a way to mitigate or gauge risk and develop a national standard for credit worthiness. In 1956, a company named Fair Isaac Company came out with a revolutionary idea; Credit Scores, also knows as FICO Scores.

How does the scoring work? FICO takes several important financial factors into account. The two most critical factors are the borrower’s payments and the balances they maintain. These items make up 65% of the score; 35% for the payment history and 30% for the balance ratio. That’s why a late payment has such a serious effect on our score. Collections are worse for us and our scores. The effect of a late payment on a loan or credit card will start to diminish after 24 months. If one has an open collection, the collection will have the same weight on their score on the last day of seven years as it did on the first day it was placed on the person’s report. The lesson here is very simple, make your payments on time and you will never have to deal with late payment issues or collections.

Balances play a role in our score if we don’t pay them down. 30% of your score is determined by the balances a person is carrying vs. how much they have available. Maintaining outstanding credit card balances by paying only the minimum payment can be very detrimental to your score. We have to make an effort to pay our outstanding balances off. For scoring purposes, the balances are added together and a ratio is calculated vs. the total amount of credit available.

The three remaining factors are our History. How long have we managed credit? That accounts for 15% of our score.

Finally, 10% each is allocated to the types of credit we manage and the number of inquiries made on our report annually.

With this data put into a computer algorithm, a number could be determined. That number would be an indicator of risk. A high number would indicate less risk is involved in lending to a person where, conversely, a low number would indicate a lower likelihood of repayment. This also led us to “FICO Score Lenders;” lenders that only grant credit based upon a predetermined level of score.

What is a “FICO Score Lender?” Typically, our major banks are using the FICO score as the primary determining factor in making their initial credit decisions. Let’s say a financial institution has 300 offices in California. On any given day, each office might send a loan application to their loan underwriting department. The underwriters, the staff who decide credit decisions, might number a dozen but receive 300 applications in one day. Prior to 1956, they would have to view each credit report to make a decision. Now, they enter the social security number of the applicant and the credit bureau gives them a number. If today’s number is 740, then any applicant with a FICO Score of 740 or above will get a further review of their loan package. The borrowers with a FICO Score of 739 or less are declined for credit as they did not make the score. Not only does the FICO Score help us determine risk, it helps lenders render faster credit decisions. Often, we can approve someone based on their credit within 24 hours.

Some may ask if using a score like this is fair. The FICO Score is basically colorblind. Credit is ultimately granted to those who have proven they can manage it well. It is typically declined for those who manage it poorly. Over the years, the score has been adjusted down for times when credit was loosened and adjusted upwards for times when we had to tighten up on the use of credit. Today, most financial institutions are looking for borrowers with a FICO Score of 740.

Are credit unions just like banks on FICO Scores? Not necessarily, credit unions generally take a more holistic approach to lending; meaning they tend to take a look at the “whole borrower,” not just their credit score. Before a credit union renders a credit decision on someone, we will take into account how long this person has been on the job? How long have they have lived in the area? How long have they been a CU member? Of course, a CU will consider their income and debt to income ratios before we provide our final decision. What this means is, if a borrower comes in with a FICO Score at 739, or 735, we don’t automatically decline their loan request. We take a wider look at our borrower to determine their creditworthiness.

Can banks help their clients with loans just like credit unions do? Sure they can, but they don’t! They will tell you they don’t have the time. It takes to much time to make decisions on marginal credit applications. Time is money and we need that money to show a profit to our shareholders.

I used to work for a bank that called itself the “Largest Financial Services Provider in the World.” One of my bosses once said to me, “We need to make profit. If we don’t make a profit, we might as well be a credit union.” As if there is something wrong with that?

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Thank you. I hope you enjoyed our history of FICO scores. If you want to learn more about credit, please attend our next Credit Myths Workshop this Wednesday the 24th at our Monta Loma Financial Center in Mountain View: 580 North Rengstorff Ave, Mountain View CA.

To RSVP for this workshop, click this link.

Credit Myths and Credit Repair
Credit Myths and Repair    April 24th at 6pm   Monta Loma Financial Center

Learn how collections, credit inquiries, and late payments effect your credit score. What is a FICO score? You will learn how to access your credit report and your credit score for free. Learn from the experts.

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