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.
