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 24^th 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.

Alternative Credit Scores

Over 70 million adults in the U.S. do not have a credit score or have a very limited credit history. Individuals and families living with limited credit files are forced to take advantage of alternative financial sources to cash their checks or get temporary short term loans aka Pay Day Loans. Users of alternative financial sources generally pay very high costs in relation to the usual transactions you might perform at your credit union. Cashing a paycheck could cost $3 - $15. A two week $200 payday loan could cost as much as $45 if paid on time. If the loan cannot be paid off right away, it has to be renewed. In California, that means the loan principle and interest has to be paid and a new loan created. How many times will a person have to pay $45 to maintain and renew the loan until they can afford to pay it off completely?

Several companies have created alternative credit scoring products based on the analysis of non-traditional data, including rental and bill payment history, insurance payments, debit-card use and public records. They are trying to use this data to predict the payment history of people who don’t have access to traditional credit products that can be tracked through a FICO score.

That is basically what a credit reporting bureau does for people with their credit. It reports the usage of the various forms of credit a person has and tracks the payments made and balances carried. Through a computer algorithm it creates a number that can predict, with fair certainty, the future payment history of an applicant. Those with FICO scores over 740 are more likely to make their payments on time and manage their outstanding balances better than someone with a score of less than 740.

Why do some people want to use alternative credit data? There is a profit motive as vendors can sell more products and services if there is a universe of more qualified buyers. It could also help families struggling with traditional credit by showing their propensity to pay their rent, utility bills, auto insurance, and other regular payments. By using alternative data, lenders stand to reach a large group of potential borrowers about whom they currently have little or no information. For these consumers, alternative credit scores strengthen lenders’ ability to:

-         Reliably rank order risk;

-         Efficiently evaluate applicants for credit or design offers for credit;

-         Increase approval rates while controlling for acceptable levels of risk

Meriwest works exclusively with Experian Credit Bureau. Experian offers various forms of credit reports. We use three specifically:

-         For all auto lending, direct lending to our members and through the Credit Union Direct Lending (CUDL) Network we use the FICO Auto 2 score. This is provided by Experian, and is a variation of the basic FICO score – more heavily weighted to the existence and performance on previous auto loans compared to the traditional FICO score.  This is similar to the “Auto Industry Option Scores” listed below.

-         For our other consumer loans, we use a custom score from Experian called a “Fast Start” score.  It is based on credit and personal characteristics such as their time on the job, how long they have been a member, and other data.

-         We also look at the Experian BK (Bankruptcy) score.  This is a predictor of the applicants likelihood of filing (or needing to file) bankruptcy, and is used as a risk measurement in our analysis.

We don’t use alternative scores, but do tend to look at our borrowers differently than a traditional bank. In a traditional commercial bank, credit score lending is King. If they are looking for a FICO score of 740 or above and that’s where you score, your application has a preliminary approval pending review of debt and income. If your FICO Score comes in less than 740, your application will be declined due to credit. They will take no further action on your behalf outside of sending you the decline letter.

Credit unions, in general, take a more holistic view of their borrowers. Sure, the FICO score is an important part of the loan qualification. Credit Unions would like to see a 740 FICO Score just like the big banks. But if you miss the score by this much (thumb and forefinger showing an inch), you may still qualify for a loan at a credit union. Why? They look at the whole person, not just their credit score. They look at how long you have been employed in the same business or the same employer. How long have you lived in the area? Or at the same home? How long have you been a member of the Credit Union? Have you borrowed from them before? All of these questions go into making the credit decisions. I am not saying that everyone with a less than 740 FICO Score gets a loan. But, if someone misses the target score by ten or twenty points, it is not the end of the loan. Credit Unions can take these questions into consideration and possibly make the loan for them at a slightly higher rate. This is called, Risk Based Pricing. If there is increased risk in lending to someone, say a 720 vs. a 740 FICO Score, we can price our interest rate a little higher accordingly to offset the risk.

Here is a run down of the more common credit scores and alternatives to credit scores:

FICO Score: Created by the Fair Isaac Corporation, FICO is the best-known credit scoring system in the United States. It is a way of measuring an individual's creditworthiness. A FICO score is a quantification of a variety of factors in an individual's background, including a history of default, the current amount of debt, and the length of time that the individual has made purchases on credit. A FICO score ranges between 300 and 850. The higher the score, the more likely that individual will pay their bills in a timely manner.

Vantage Score: A consumer credit rating product developed by three credit rating agencies - Equifax, TransUnion and Experian - as an alternative to the FICO Score. VantageScore uses a different rating scale (501 to 990) than FICO (300 to 850), and is branded as a score that provides lending institutions and banks information related to sub-prime financing. The score is calculated through a weighted average of a consumer's available credit, recent credit, payment history, credit utilization, depth of credit and credit balances.

Auto Industry Option Scores: Auto lenders are unlike other kinds of creditors. Many other creditors look at the entire credit picture to make a decision. However, some auto lenders base their decision solely on how previous auto loans were managed. So, even if your credit scores are bad, if you never missed a car or truck payment or sent one in late, your Auto Industry scores will most likely be higher than the standard FICO scores.

Veritas (by Digital Risk): Most recent alternative; used for home mortgage credit analysis. It Integrates borrower credit characteristics with property and local real estate market data along with proprietary behavioral prediction models. 

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Our next Credit Myths workshop is this Wednesday the 5th of December

Credit Myths and Repair

6:30pm    Wednesday    December 5th 

Meriwest Credit Union Main Office

5615 Chesbro Ave, San Jose CA 95123

Click here to RSVP!

Your FICO Score-Mystery no More!

 

Is your FICO score a mystery to you? Don’t feel bad, most American consumers don’t know their FICO score much less how it is determined. Generally, your FICO score can vary from 300 at the lowest to a high of 900. People ask me, “Hey, Credit Union Guy, what’s a good credit score?” Today, a good score would be in the neighborhood of 740. At this level you can access good rates on car loans, home financing, and credit cards. Go below 740 and you may find yourself paying higher rates of interest on your loans and credit cards.

“What is a FICO?” FICO is an acronym for the Fair Isaac Company; the company that invented the calculations that result in a measurement of credit risk. The score is determined by an algorithm. In a sense, it is a highly complex algebra problem that takes into account your payment history, the ratio of your loan and card balances vs. your available balances, the length of your credit history, your credit request inquiries and the types of credit you are managing. The formula for exactly how the score is calculated is proprietary information and owned by Fair Isaac.

“Why does the FICO score exist?” In the old days of lending, loan managers looked at the physical credit report for a person and made a judgment call on the risk involved with making a loan to that person. Back then, two loan underwriters might look at the same report and have very different opinions on the applicant’s payment history. Credit Scoring took the judgment call out of the process. A person either scored well or they didn’t. Another reason for FICO score is volume. As our population grew and more people started using banks and credit unions, the loan volume increased significantly. In order to speed the loan process, the FICO score was used. Loan processors can input a minimum of data and get a score for a credit decision rather than reviewing the entire credit report.

Here is an approximate breakdown of how it is determined:

·   35 percent of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how timely) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection, any bankruptcies, etc. When these things happened also comes into play. The more recent, the worse it will be for your overall score.

·   30 percent of the score is based on outstanding debt. How much do you owe on car or home loans? How many credit cards do you have that are at their credit limits? The more cards you have that have maxed out lines, the lower your score will be. The rule of thumb is to keep your card balances at 30% or less of their limits.

·   15 percent of the score is based on the length of time you've had credit. The longer you've had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions.

·   10 percent of the score is based on the number of inquiries on your report. If you've applied for a lot of credit cards or loans, you will have a lot of inquiries on your credit report. These are bad for your score because they indicate that you may be in some kind of financial trouble or may be taking on a lot of debt (even if you haven't used the cards or gotten the loans). The more recent these inquiries are the worse for your credit score. FICO scores only count inquiries from the past year.

·   10 percent of the score is based on the types of credit you have. The number of loans and available credit from credit cards you have makes a difference; installment loans vs. revolving lines of credit. There is no magic number or combination of types of accounts that you shouldn't have. These actually come more into play if there isn't as much other information on your credit report on which to base the credit decision.

Questions? Ask the Meriwest Credit Union Guy at gmeyer@meriwest.com.

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The next Meriwest Credit Union Financial Education Workshop will be our Reality Based Budgets Workshop for teens and college students on Wednesday, Nov. 28th at our Monta Loma Financial Center in Mountain View. This workshop takes through a post college money management simulation where they are given a salary, rent, car payments, and other bills and build their living budget. 

Our Monta Loma Financial Center is located at the corner of Rengstorff and Middlefield  Road in the Monta Loma Shopping Center. The program begins at 6pm. We hope you can join us. Please RSVP at our Events Link.

 

Does Good Debt Exist?

Good debt does still exist. Home debt, if you are not dramatically underwater is still good debt. Please remember that the majority of home owners have seen some degradation of their equity, but most homeowners are not underwater. The generally accepted number is somewhere between 20-25% of all homeowners have a home that is underwater. Most of these were either purchased or refinanced during the recent boom in prices, especially 2005 to 2008. It is a simple truth that 75% or more of all U.S. homeowners are not underwater. Homes purchased today with a reasonable downpayment of 20% or more may have some stagnant price growth in the near term, but historically, owning a home is a sure path to wealth creation. When you consider the tax advantages of owning a home and the increase in value even if it only follows regular inflation rates, new homeowners will incur good debt.

Is college debt good debt? Many are of the opinion that education is important and the resulting debt from financing it is still a good debt. That is provided the student finishes and graduates. Statistics show that lifetime earnings of those with bachelors and masters degrees are substantially higher than those with only a high school education. I have many former college students in my workshops who have not graduated and have substantial student loan debts. Those debts become good debt and will be well worth it when they finish their degrees.

Is all credit card debt bad debt? Not necessarily. Often, young persons will use a credit card like it is going out of style. They will pay for movies, dinners out, concerts, and other fun items with their credit cards. That is some bad debt; debt where you have little or nothing but memories to show for it. I think the responsible use of credit cards is in purchasing assets for your home or car. Use the card for furniture, needed appliances or a major car repair. That way, when you are on your couch writing a check for your Visa card payment, you are sitting on your asset. (A little finance humor.)

Vehicle debt can often be termed good debt. Your car is an economic development vehicle. It gets you to work on time and gets your kids to school. Is spending 2 hours plus on a bus or train daily the best use of your personal time? It is a matter of opportunity cost. How much is your personal time worth?

In the end, I think that the difference between good debt and bad debt is subjective. Our income, education, and cultural background all play a role in how we view the value, really the personal value, of our debt. 

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Our next financial workshop:

Today's Real Estate Market and Tips for Purchasing Foreclosed Property
Saturday, October 13, 2012 - 10:30 a.m.
Chesbro Financial Center, San Jose, CA

Living at Home Again: Financial Advice for recent Boomerang Kids

Recently I had an email from Bill H. who is a recent college graduate but was unable to find a job immediately in the current job market. He turned up on his parents’ doorstep like many other recent grads. This is often referred to as the Boomerang Effect: students returning home after college rather than striking out on their own right away. Often, this is not by choice; the student would rather be working and on their own.

He wrote:

Dear Credit Union Guy,

After graduating I had to move back home until I find a job. Do you have any tips for managing my finances at this stage in my life?

Bill H.

Dear Bill,

Here are some points for you and other Boomerang Kids:

• Don’t take on any new debt while unemployed! Save your money to make the payments you need to make on any current student loan, car loan debt or credit cards.
• Don’t ever use a credit card for entertainment purposes while unemployed. I have seen far too many pizzas, movies, and concerts on students’ credit cards. They have nothing to show for this debt that they are paying it off at 19%! Ouch!
• Make all your payments on time. Late pays will show up on your credit report and many employers use a credit report to determine the personal responsibility of potential new employees. Current payments mean you will get out of the house soon. 30 and 60 day late payments may cause you to sleep in the bunk bed with your little brother for a while longer than planned.
• Maintain your checking account, make regular deposits to cover your outstanding checks and debit card charges. If your account goes into a negative balance, get it positive quickly. Most financial institutions will only maintain a negative checking account for 30 days. Then they close it for cause and report any losses to a collection agency and ChexSystems, a credit reporting service for financial institutions. If you get reported to ChexSystems by your bank or CU, a ChexSystems record will prevent you from opening a new checking account at a member institution for the next five years! Most banks and credit unions are members of ChexSystems. Trust me, you don’t want your parents seeing mail for you from ChexSystems and collection agencies. That does not make for pleasant dinner conversation.
•  Make sure you have the address of your student loan company and the payment due data for your loan. Generally, six months after you graduate you have to start paying your loan. If you are not employed, you can ask your student loan company for a deferral in payment; this is known as forbearance. Interest will still accrue on the loan and be added to the balance, but payments will be deferred for six more months.

Bill, you are not the first kid to come home after college and you won’t be the last. Returning to home after college can be a stressful situation for students and their families. It is not what you expected to do when you finished your college degree and it is not what your parents expected either. But you can make the best of a difficult situation.

Don’t let your finances become a regular topic of conversation at your family’s dinner table. While living at home and looking for your dream job, don’t overlook getting a part time job to make some ends meet. A little bit of income is better than no income at all and it helps pay your bills. Manage your debt well and keep on top of your checking account. In the end, you will be respected for handling your personal finances in a very mature manner.

Best of luck,

The Credit Union Guy

And for all of you out there looking for our next financial education workshops, your summer wait is over. Our next workshop will be "Reality Based Budgets for Teens" at our Milpitas Financial Center at 6PM on Aug. 22nd. 

Our next "Credit Myths and Repair Workshop" will take place at our Milpitas Financial Center on Aug. 29th at 6PM. 

I hope I will meet you at one of our seminars! Have a great week!

Credit Reports and Employment Background Checks

For jobs that require a high degree of trust and responsibility, a background check is required. Part of that check includes a review of your credit report.

In the business of finance, credit reports are critical to the hiring process. You would not want someone handling your money if they could not manage their own! The credit report can tell us a lot about our potential employee. It gives us insight into how responsible they are with their money and credit. The thinking is, if someone is responsible with their own money, they will be accountable and reliable when given responsibility for your money.

But, right now, it can be difficult to find someone who has been unemployed for a while with perfect credit. We are seeing people with a number of credit issues applying for jobs. The bottomline is: Honesty is the best policy. My HR team appreciates when an applicant is upfront about their credit status and speaks to us about the deficiencies in their report. In example, “I have been out of work for six months and had to make several concessions to my budget to make ends meet for my family. I have one Visa account that is 30 days in arrears and I am two months behind on my mortgage. I should be able to bring these items current within two months of being hired.”  In these recessionary times, we need to be flexible and do our best to see the entire employee and not focus on one or two aspects of their past credit behavior. If someone were to be upfront with us regarding their past credit, we would appreciate their honesty. It is best to know ahead of time and not be surprised than the other way around.

Credit checks or inquiries for employment do not show up on credit reports requested by employers or creditors. Where you apply for work is none of their business. Those inquiries only appear on your copy report if you request it from a credit bureau or if you order it through WWW.AnnualCreditReport.com.

A person has the right to add a 100 word statement to their credit report at anytime should they feel the need. In the case of someone being unemployed or underemployed for a length of time, one could place a message on their credit report with all three credit bureaus that they were unemployed from xDate to xDate and had to allow some bills fall into arrears.  The message will stay on the report for 7 years. This message also plays for someone who was disabled and unable to work for a time. These messages will not help you access further credit, but may be helpful in accessing employment or rental housing. 

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Are you looking for a new car this summer? Tired of feeling you paid too much for your car? You can make a change by contacting Bill Fultz, our Personal Auto Shopping Service Manager.  Bill is an Auto Broker who works for our members for FREE! Bill can get you the best deal on new and used cars; often at invoice or below. Learn more about our Personal Auto Shopping Service on our PASS Page.