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?
* * *
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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