Keeping Score on Credit
The use of credit scores and reports dates back nearly 60 years. In 1956, engineer Bill Fair and mathematician Earl Isaac formed the Fair Isaac Corporation (FICO) on the premise that data could be mined and used to inform business decisions. Two years later, the company rolled out its first credit scoring system. FICO honed the score and currently sells it to banks, insurers, retailers and credit card companies. As the company declares on its web site, the use of its data and mathematical algorithms “to predict consumer behavior has transformed entire industries.”
The current FICO score ranges from 300 to 850. Borrowers with scores above 750 are generally considered excellent, while scores below 650 are considered poor. The three most important factors that determine your score are: Payment History (and especially paying bills on time); total debt outstanding, which takes into account how many accounts you have and how close you are to your credit limit; and the number of inquiries made into your credit file. Inquiries are broken into "soft" (for preapproved offers; for insurance or employment purposes; and for when you check your own credit report or score) and “hard” inquiries, like when you are shopping for a mortgage, auto or student loan can. Soft inquiries do not hurt your score, while hard ones count against you.
The use of credit scores was less important in the run up to the financial crisis, when in the year of easy credit, it seemed like anyone with a heartbeat could borrow money. But in the aftermath of the Great Recession, financial institutions would only lend to the best borrowers with the highest scores.
Not only has the FICO score has transformed businesses, it also has assumed a major role in the financial lives of consumers. Credit reports and scores are being used for more than borrowing and lending. Landlords often use credit data to research potential tenants; and in many states, it is perfectly legal for prospective employers to check credit.
The ubiquitous use of credit scores makes their accuracy all the more important. If scores are lower, due to bad data or error-ridden reports, a consumer’s cost of borrowing could be higher than it should be or their living arrangements or job prospects could be negatively impacted. Unfortunately, the Consumer Financial Protection Bureau conducted a 14-month probe, which found that it is notoriously difficult for consumers to correct credit report errors.
As regulators continue to oversee the rating and scoring industries, there could be good news for millions of consumers with shaky credit. FICO is testing a new product, which is calculated using consumers’ payment history with their utility companies. You probably didn’t realize that over 70 cable companies, cell phone companies and utility providers already contribute to a national database called the National Consumer Telecom & Utilities Exchange (NCTUE), on which Equifax already reports.
The new score will also incorporate data from LexisNexis, to determine how often people change addresses -- frequent changes suggesting less stability and greater risk for the lender.
FICO is developing the alternate score to sell to its clients, who are trying to determine how to make loans to – and money from – those consumers who otherwise wouldn’t qualify; and as a result, have been shut out of mainstream borrowing. There is a vast market—according to FICO, 53 million Americans currently have credit scores that are unacceptable to lenders or don’t have scores at all.
While gaining access to credit could help many, chances are, banks will charge riskier borrowers higher interest rates and pile on extra fees. Additionally, young adults will need to be conscientious about paying all of their bills on time, else risk seeing a ding on the new credit score. They also may worry about frequent address changes.
Finally, critics of the new score believe that lending money to shaky borrowers is one of the factors that contributed to the financial crisis and should be avoided at all costs. Or in honor of the start of baseball season, it could be what Yogi Berra once called "Deja-Vu all over again."