Posted by: kvan in Open House, Gerri Willis, FICO, Fair Isaac on Feb 18, 2009
Gerri Willis, author and host of CNN's "Open House" wrote about the new FICO '08 formula for determining creditworthyness in this article. As you know, the FICO score determines creditworthiness in the eyes of almost every creditor. It determines whether you are approved for a loan, and what interest rate the creditor will extend you. Insurance companies vary rates according to your FICO, some employers and potential landlords also use the FICO to guide the price you get charged for their products or services.
According to Gerri, Fair Isaac, the company that develops the formula (Fair Isaac is the ‘F' and ‘I' in ‘FICO'), has created improvements, especially for consumers in the 600-700 score range, the so-called subprime borrower. Several improvements were announced. The new scoring model ignores credit issues concerning values less than $100 dollars. Presumably, paying late on a small "nuisance" debt has very little correlation with how you perform on more important loans like a mortgage, auto, or even a credit card debt.
Also, a sporadic missed payment is ignored by the new formula, as long as you don't have any serious infractions in your credit history. Missing a payment because of vacation or other distracting event no longer counts against you, as long as you've proven yourself creditworthy in other areas.
Finally, the new formula refines how "authorized users" are treated in the credit formula. An authorized user is a spouse or other family member using your account. In years past, some credit counselors discovered they could improve a consumer's FICO simply by listing them as an authorized user of an unrelated individual with excellent credit. This loophole is closed, without penalizing legitimate authorized users.
These changes seem very logical, and amount to an admission by Fair Isaac that the formula previously ignored important nuances that may have been too difficult to discern. The change in credit predictability for subprime consumers should result in higher scores for many, thus more credit approvals and better interest rates for these consumers. These consumers will save money and be treated more fairly by financial institutions.
For their part, Fair Isaac is understandably proud of their accomplishments in improving the formula. Fair Isaac notes in several press releases that the improvements are a "patent-pending breakthrough" that "can deliver a 5%-15% lift in predictive performance". Fair Isaac promotes the new accuracy as a way for financial institutions to increase the number of loans. Higher confidence in risk categories should encourage banks to lend more at the appropriate interest rates.
With the increase in fairness, one would expect the credit reporting agencies, Experian, Equifax, and TransUnion, would quickly replace the old FICO formula with the new. Not so. According to Gerri, "It's not likely to happen anytime soon... It could take months, even years before these changes become reality for folks".
Why would it take so long to implement a formula that increases fairness and saves money for many consumers? Apparently, what's good for the folks is not such a great deal for those on the other side of the equation. The financial institutions, who we now know are overcharging many subprime customers because of flaws in the old formula, are the main revenue stream of the credit reporting agencies. They don't seem to have a vested interest to push for the new FICO formula. In fact, they could lose money, as they no longer could exploit the borderline consumer who actually is a very good credit risk, even though the old formula shows them to be risky. Banks collect more interest from these consumers because of the flaws in the old formula.
Of the three major credit reporting agencies, TransUnion seems to be the only one that has adopted FICO '08, according to an examination of each credit agency web site. With just one agency using the new formula, I decided to run a little experiment. My wife, who is generally trustworthy, recently missed her Kohl's payment. It was what I would consider a "nuisance" payment, around $45 dollars. Of course, it's not acceptable to miss payments to any creditor, but it's easy to get overlooked among payments for mortgage, auto, and several credit cards, in the midst of a hectic life as a working mother of 4. My wife has never defaulted on a loan, and never been 60 days late among literally thousands of payments across a 25 year credit history. Based on a credit report from Experian, I know her FICO was hit hard from the late payment, falling from around 700 to 670 after Kohls reported. Based on what I know of the FICO '08 formula, I hypothesized that my wife's score at TransUnion, now using FICO '08, would be higher than Experian. I went to the TransUnion site, and signed up for a free 30 days of score tracking from all three credit reporting agencies. What I found was heartening. The scores reported for the three agencies: TransUnion: 710, Experian: 670, Equifax: 680. With a sample size of one, my experiment is not scientific, but it certainly supports claims that the new score is more forgiving of minor transgressions.
It seems that the new FICO formula makes perfect sense. The trick now is applying pressure to financial institutions and the credit reporting agencies to adopt it. I have sent questions to both Equifax (where I'm a customer) and Experian (where my wife is a customer), asking when the new rules will be adopted. I will follow up here when I get answers. I will also send notes to my congressmen to make sure they are aware of a potentially exploitive situation. I encourage others to do the same.