FICO-free zone? Traditional credit scores aren’t going anywhere

FICO credit scores aren't going anywhere

It’s a familiar memory for many people who grew up in the 1980s or early 199os: Upon finishing high school or enrolling in a four-year university, you would receive an advertising packet from Visa, MasterCard or AMEX offering a student credit card with a low credit ceiling, coupons for discount concert tickets or airfares, and automatic approval. Using the card responsibly and paying off the balance every month was an important step into adulthood and virtually the only way young adults could establish a solid credit score. They were almost essential for securing the loans people would eventually need for the high-cost demands of the modern world: like, car loans and mortgages.

But as adulthood creeped up, the credit scoring provided by FICO somehow became more opaque. The company provides credit analytics to banks and traditional lenders on over 90 percent of loans made in the United States, but most people were unaware of the exact components that went into FICO’s determination of an individual’s credit worthiness.

To address this issue, FICO has just released a rating estimator to shed light on the process for potential borrowers. The predictor leads the user through a series of 10 questions focusing on current and past credit history, including number of credit cards, number of outstanding loans, and negative financial indicators such as defaults and bankruptcies.

But like most of FICO’s scoring products, the credit estimator cannot evaluate risk or issue a credit score without a credit card history of at least six months. That means the company cannot rate a 2012 college graduate with a solid job, no outstanding debt, a history of paying bills on time and $30,000 in savings, for instance. Or a 28-year-old with a solid employment history and savings but who spends responsibly and pays for goods and services in cash or with a debit card. Turning to lenders who rely solely on FICO scores, both of these individuals would be hard pressed to obtain a car loan or mortgage.

The demise of FICO?

That hole has led some to predict the demise of traditional credit ratings that consider only a person’s credit card history, and even of FICO itself. In January, a death knell was sounded for the company’s backwards-looking method of analyzing credit worthiness, a view seemingly shared by the Wall Street Journal. The publication noted not only that FICO’s scoring mechanism considers a range of credit history data before issuing a detailed report and credit score, but also the fact that the final ranking does not consider relevant information about a borrower’s current status – factors such as age, salary, occupation, title, address, employer, date employed or employment history.

At first glance, the prediction seems to have merit. Some online lenders, such as Social Finance, say they have abandoned FICO scores altogether. Others, like Avant, say they have significantly reduced their reliance on FICO in favor of a more holistic view of credit reliability. And alternative credit evaluators such as PRBC (Pay Rent Build Credit) and Ecredable stand to further disrupt the credit market by considering metrics such as phone, gas and electric, insurance, cable and daycare payments when evaluating a loan request.

The rise of alternative credit evaluators would indeed appear to pose a challenge to a company that primarily offers analysis of a potential borrower’s credit card use, especially given the additional fact that many millennials no longer see credit cards as a necessary facet of life. As many as 63 percent of adults under 30 years old don’t have one, according to a survey commissioned by Bankrate, in contrast to just 35 percent of adults over the age of 30 who don’t have credit cards.

“If I had the option of cash flow or FICO [when evaluating applicants], I’ll take cash flow every single time,” Mike Cagney, the chief executive of Social Finance, told The Journal in January.

On the other hand, marketplace lending giants Funding Circle, Lending Club and Prosper (not to mention the enormous traditional lending industry) continue to rely on FICO scores to evaluate loan requests.

FICO counters with a new score

Even more significantly, in 2015, FICO, together with LexisNexis, and Equifax, announced a pilot, FICO XD, to incorporate alternative data such as property records, telecommunications and utility information when evaluating risk and providing credit scores. That will likely open up credit approval for as many as 53 million Americans who wouldn’t be approved for loans using traditional credit card-based ratings, either because they do not yet have mature credit profiles, they choose not to use debt or because they have been shut out of mainstream lending due to a negative credit event, such as bankruptcy or foreclosure.

One cannot overstate the significance of this final point. Whereas doomsayers have tried to portray FICO as an outdated has-been with little to offer a new generation of borrowers and lenders, FICO XD neatly illustrates the company’s ability and willingness to innovate and respond positively to current trends in the credit market. It’s a point that investors have apparently internalized as well: FICO’s stock price has climbed nearly 500% since September 2011.

Ultimately, then, predictions that FICO is going the way of the open outcry options trading pit would appear to be overstated and simplistic. With a market cap of $3.33 billion and a market share of 90 percent of the lending market in the United States, the company is well positioned to meet the challenges posed by technology upstarts that promote new models of risk assessment.

5 surprising things you might not know about FICO

surprising things about FICO

It’s hard to read anything about the rise of online lending without touching upon the demise of the FICO score. FICO may not be the word’s most perfect credit scoring methodology, but for the most part it’s held up through multiple credit cycles. Many upstart online lenders have developed tools to compete with, or even replace, the traditional scoring mechanism, but in actuality, financial institutions are showing increasing interest in FICO scores, not less.

Here are 5 surprising things you may not know about the FICO score:

FICO usage is going up, not down: If you pick up any mainstream business press, you’ve probably read about the death of the FICO score. As part of their business plans, many online lending startups have targeted borrowers who traditionally struggled to access credit from traditional sources. Many of these potential borrowers aren’t scored by FICO because they lack credit history. Oftentimes, it’s because they’re too young to have used credit cards. So, to extend credit, many of these firms had to build their own credit models.

But when you look at the numbers, FICO is being used more, not less, in today’s market. FICO scores are used in 90% of all credit decisions, according to research firm CEB TowerGroup, amounting to 10 billion scores every year. So, even if student loan lender SoFi announced its firm was now FICO-free, FICO scores are indeed ramping. In the 3rd quarter of 2015, FICO’s Scores division saw its revenues rise 27 percent over the same period last year.

FICO does have a solution for millennials: One of the dings people have on FICO is that its credit models are backward-facing. These historical models, which first hit the market in 1989, give weight to past behavior, but pay little attention to current reality. If you paid your bills on time in the past, according to FICO, you’re likely to continuing doing so in the future. But what about a millennial who never had any bills in the past? FICO has had a hard time scoring this type of person. Instead, some fintech firms have built a millennial’s earnings trajectory into their credit models to make sure they can extend credit to the unscored.

But, FICO has developed its own scoring mechanism to deal with non-traditional borrowers. Called Fico XD and developed in tandem with LexisNexis Risk Solutions and Equifax, XD goes after previously unscorable borrowers. XD uses a mix of landline, mobile, and cable payment history and combines it with credit bureau information, if it’s available, and public and property data. According to the firm, this means 50% of previously unscorable credit applicants can now be scored. The Consumer Financial Protection Bureau reported that as of 2010, about 8.3% of adult consumers, or 19 million people, were considered “unscorable” because their credit history was inadequate. FICO claims it will include an additional 50 million people under XD’s scoring methodology.
FICO stock at an all-time high

FICO stock is at an all-time high: FICO, the company, was formally known as the Fair Isaac Corporation. It’s based in San Jose, California, and was founded by Bill Fair and Earl Isaac in 1956. While there’s been a lot of speculation about the future of FICO in light of the excitement around newer credit models, the company doesn’t seem to be feeling the heat just yet. The software company did close to $800m in revenue in 2014 and its stock trades at an all time high.

“I think some of the headlines reflect a bit of a desire by some of these alternative lenders to stir up controversy,” CEO William Lansing remarked on a recent earnings call. “We’re not really seeing it in our numbers. We’re not selling fewer Scores. In fact, we sell our Scores to many alternative lenders and those volumes are going up not down.”

There’s actually more than 1 FICO score: Though we normally think and talk about FICO scores as if there were only one score per person, the truth is that there are multiple scores on our creditworthiness. The most widely used score by all 3 credit bureaus (Equifax, TransUnion, and Experian) is FICO Score 8. Beyond that, FICO has developed multiple scoring methodologies it uses in auto lending, credit card decisioning, and mortgage lending.

FICO continues to evolve its scoring practices, which results in multiple scores. A lot has happened since the firm debuted its first score to the market in 1989. Lender credit-granting requirements, data reporting practices, consumer demand for credit, and consumer use of credit have all evolved. As the firm releases new scoring practices, lenders choose for themselves whether or not to upgrade to the newest version.

Figure 1: Dynamics of Credit Score Gaps of Lasting Spousal Relationships
Dynamics of Credit Score Gaps of Lasting Spousal Relationships

Beyond measuring creditworthiness, FICO scores also measure romantic compatibility: Maybe, instead of asking someone you meet at the bar what his or her major is, it’s a better idea to ask about their FICO score. That’s because new research has shown that big differences in credit scores could prove disastrous to a relationship. In Credit Scores and Committed Relationships, researchers for the Brookings Institution looked at data from The Federal Reserve Bank of New York Consumer Credit Panel and from credit bureau, Equifax, covering the 15-and-a-half years through the second quarter of 2014.

While the researchers didn’t exactly use FICO scores for their research, they did find that a “couples’ average level of and the match quality in credit scores, measured at the time of relationship formation, are highly predictive of subsequent separations.” Similar credit scores, if relatively high, are also predictive of lasting relationships.

In other words, couples that spend together, pay their bills together, and make sure they use proper utilization of their credit lines, stay together.


Photo credit: stevendepolo via Visual hunt / CC BY