A Fool's Guide to Credit Scoring

By Paul Commins (TMF Buster)
August 7, 2000

In search of: Soul-mate to share sunsets by the lake and maybe more. Must be gentle and kind. Prefer FICO score above 720.

Don't laugh. Personal ads like the one above could start popping up on the singles scene soon. Until recently, FICO scores -- the lending industry standard for quick, objective assessment of consumer credit risk -- were a fiercely guarded secret. Few consumers knew that these scores were included on most credit reports; even fewer saw them. Credit bureaus that license the software for generating these scores agree not to share scores with individual consumers. Banks are not obligated to show them to you either, although some may if you ask.

But, times are changing. An informal alliance of strange bedfellows is circling the wagons around tiny Fair, Isaac & Co. (NYSE: FIC), the brains behind FICO scores, and it's starting to look like credit scores will soon work their way into the popular online financial consciousness, one way or another.

To keep you up to date on this important topic, Fool, we've prepared this Q&A. As usual, if your question isn't answered here, please raise it on our discussion boards!

OK, what's a credit score?
Think of credit scoring as a black box. A consumer applies for a loan or a credit card, generating an order for her current credit profile. In addition to producing a detailed report, the credit bureau -- on request -- will also feed her credit history into the credit-scoring black box. The box spits out a three-digit number, typically between 500 and 800, which is entered into the report. The higher the score, the better chance her request will be approved.

Here are two key points to keep in mind. First, not all of these black boxes are identical and each credit bureau is likely to have a slightly different set of information on you. Change the input and the black box and the output is likely to change, too. Moreover, credit-scoring methods typically weight recent history more heavily than past history. Seen in all this context, then, it really makes more sense to talk about your credit scores; they will change, both across credit bureaus and over time.

Second, it's no longer just a matter of getting approved. More and more, lenders are offering the lowest interest rates -- and instant approval -- to applicants with the best credit scores. So, these scores are of potential interest to all consumers, not just those wrestling with rejected applications.

Where does Fair, Isaac & Co. fit into this picture?
Started in 1956 by a couple of mathematicians named -- oddly enough -- Fair and Isaac, this little company has virtually cornered the market in consumer credit scoring. Its key assets are intellectual property -- statistical techniques built over decades of trial and error. Formerly focused on the credit card market and auto loans, Fair, Isaac has moved aggressively into the mortgage business in recent years. According to the company, it is now the credit score of choice for 75% of all mortgage applications.

Fair, Isaac draws representative samples from large data files covering the past history of individual consumers. Manipulating complex combinations of credit variables -- for example, number of late payments (over 30 days), number of really late payments (over 90 days), number and age of open credit accounts, total debt outstanding and total credit available -- they hunt for patterns that isolate consumers in the historical samples that proved to be a bad credit risk. The basic assumption is that applicants who "look" like past defaulters -- in the history files -- are the most likely to be future defaulters.

This learning from past data is built into the black-box computer programs that generate credit scores. These computer programs are licensed to the big three national credit bureaus or credit reporting agencies (CRAs).

How did Fair, Isaac get to be so dominant?
Fair, Isaac's history of optimization is critical because its ultimate customers -- lending institutions -- count on these credit scores to boost their bottom line. If a scoring method picks off too many applicants, the lender will lose revenue; pick off too few and the lender will suffer increased costs via a higher rate of unrecoverable loans. The more precise the method, the higher the profits.

Moreover, there is great power in being the industry standard for credit scoring. Would you want to be the first executive at a major bank to suggest a nonstandard system for handling credit risk? If loan defaults or denied customer lawsuits happen to trend upward, wouldn't it be nice to have the standard behind you?

Why doesn't Fair, Isaac want me to see my score?
When pressed for greater consumer access to credit scores, Fair, Isaac spews a lot of hooey about consumers not being sophisticated enough to interpret credit scores without the expert context provided by a lender. To Fools, this sounds a lot like, "most people aren't capable of making their own investment decisions and should hire a broker."

If you look at it from a business perspective, the true reason for Fair, Isaac's secrecy is crystal clear. The company is trying to protect its intellectual property. If the guts of its scoring methodology is made public, two things could happen. First, some high-risk consumers could learn how to "play" certain elements of the system, reducing its effectiveness and, hence, its value to lenders. Second, it might be easier for competitors to duplicate Fair, Isaac methods.

How does Fair, Isaac get away with this secrecy?
In many ways, the success of Fair, Isaac has been good for consumers. The cost of bad loans, to some extent, is carried by consumers that don't default. And, assuming an efficient market for loans, reduced costs for lenders have translated into better rates for consumers.

Also, it is illegal to feed variables like gender, race, and religion into credit-scoring systems. It can be argued, as a result, that the availability of an objective, industry-standard credit score has reduced the level of prejudice in the lending industry.

So, why is Fair, Isaac under so much pressure?
Objectivity, alas, is a double-edged sword. The plain, indisputable fact is that no computational procedure will ever capture the true risk of default for hundreds of millions of American consumers, no matter how complete the input data or how monumental the statistical edifice. When applied to very large populations, the tiniest of failure rates will result in some real-life mistakes. You can be sure that somewhere, somehow -- as you read this -- a creditworthy American is being denied credit based on a FICO score.

Even more frustrating, though, is the opaqueness of the FICO black box. Fundamental questions regarding how to improve one's FICO score are hard to answer, even for career mortgage lenders. The basics are obvious: pay your bills on time. But, good luck getting a straight answer to obvious next-level questions like: "How many credit cards is too many? Too few?" And, the part that really riles most consumers is not so much that the scores are used, but that we can be forced -- like rats in a Skinner box -- to work towards a goal without easily accessible feedback or a clear understanding of the rules.

You mentioned that times are changing. How?
With pressure mounting from all sides, Fair, Isaac recently relented -- a little -- posting on its corporate website the most complete, public description of FICO methods to-date.

The Internet has delivered a disruptive blow in the form of new business opportunities. Yahoo! and other portals have revealed that there is big money to be made in providing real-time personal finance data and, given this trend, it was just a matter of time before consumers discovered and demanded FICO scores from their Web browsers.

And, for a while, E-LOAN delivered -- shaking up the industry by passing FICO scores on to thousands of customers earlier this year. Predictably, Fair, Isaac freaked, and closed down the practice by exerting pressure on the CRAs -- its direct business partners -- to cut off E-LOAN.

But, Fair, Isaac has been unable to stem the tide. Most recently, mortgage powers Freddie Mac and Fannie Mae have taken steps to open up their own proprietary credit-scoring systems, and have stepped up calls for Fair, Isaac to do the same. Even the big-three CRAs are getting into the act -- with TransUnion promising its own Internet-available scores by year's end and the other two rumored to be following suit. These alternative scores will not be the standard, for the time being, but they will be open and easily accessible, perhaps leading to a greater role for them in the future.

In the meantime, how do I maximize my credit score without feedback?

  1. Pay your bills on time, especially mortgage or rent payments. Apart from extreme circumstances like bankruptcy or tax liens, nothing has the impact of late payments. Anything more than 30 days late will hurt you. Never let a payment of any kind -- even phone or utility bills -- get 90 days past due.

  2. While nobody can tell you exactly how many credit cards to own, it's clear that not having any is likely to reduce your credit score. Having clean, active charge accounts established many years ago will boost your score. If you are adverse to credit, on principle, consider setting up automatic monthly payments for, say, utilities and phone on a credit card account and locking the card away where it's not a temptation. The sooner you get started the better, if you are currently renting but plan to buy a house someday.

  3. Beyond one or two credit cards, it starts to get complicated. It's not always a good idea to cancel extra cards, although it is always a good idea to keep the ratio of total owed to total credit available as low as possible (i.e., don't carry large balances from month to month).

  4. Be careful not to apply for too much credit in a short amount of time. Multiple requests for your credit history (not including requests by you to check your file) will reduce your score. If you are hunting around for good loan rates, assume that every time you give your Social Security number to a lender or credit card company, they will order a credit history.

    If you are using a loan search service on the Internet, ask how many credit file inquiries will be generated in the search and try another method if they can't keep this number low. Fair, Isaac claims to have improved its methods for clustering rapid strings of inquiries, so that they are treated as one, but it's safer not to even take the risk, if possible.

  5. Check your credit history for errors, especially if you will soon be requesting a time-dependent loan, like a mortgage. All three national CRAs -- Equifax, Experian, and TransUnion -- have consumer ordering information on their websites.

Where can I get more information on credit scores?