by The Ascent Staff | Oct. 7, 2019
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You are more than your credit score, and FICO may be missing the mark.
Have you heard of Fair, Isaac and Company? I'll give you a hint: It's not a department store. It's a self-described analytics software company that you probably know as FICO. Ah, yes. Bells of recognition are ringing, and beads of sweat are forming.
FICO is the best-known provider of credit scores. It uses a complex model to evaluate your credit history and produce a FICO Score, which lenders use to determine how likely you are to repay your debts.
For decades the FICO Score has been lenders' gold standard, but it isn't the only game in town. VantageScore is a product put together by Experian, TransUnion, and Equifax, the global leaders in consumer reporting. VantageScore and FICO have the same objective, but a FICO Score is more widely used and recognized. It's the magical number that governs many of our financial practices. Individual FICO Scores often determine what people pay for the privilege of borrowing money to purchase cars, homes, and more.
With so much of an individual's life tethered to one three-digit number, it's important to know whether this calculation focuses on what really matters. From time to time the FICO model has been updated to reflect current consumer behavior, but the core elements remain the same. With this in mind, one may question whether or not a model designed more than half a century ago is an accurate representation of modern creditworthiness.
The base FICO model considers the following five components:
Those five factors offer valid, but incomplete, information for determining lender risk. The FICO model is designed to spot and predict patterns, but in the process, it can miss some key nuances when evaluating an individual's financial behavior.
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At some point, most people will be affected by illness, job loss, or other hardships. If you get sick and are unable to work, you may fall behind on your bills for a while, resulting in a negative mark on your credit report. And once you're able to work again, that unusual circumstance could be held against you for yours.
Computerized models may fail to consider special circumstances that would justify a shift from otherwise responsible behavior. A dependable borrower could be denied a loan due to a temporary hardship. No one wins in this situation. The lender loses potential interest revenue, and the buyer is deprived of a purchase opportunity.
Another missing facet of FICO scoring is the overall value of a potential borrower. Net worth is the value of the things you own minus the value of your obligations. If what you own is greater than what you owe, then your net worth ought to count in your favor. In a situation where money is tight, those with positive net worth could convert some of their assets into cash to satisfy debt payments.
The five FICO factors ignore savings, checking, and money market accounts, as well as any other investment holdings easily convertible to cash. The lender's objective is to ultimately recover its investment with a profit. All reasonable means of repayment should be considered when evaluating a borrower's ability to repay.
Seemingly harmless decisions like closing a credit card can have a negative impact on your credit score. You might close a card you're no longer using or ask your card issuer to lower your spending limit in an effort to be fiscally responsible. However, the devil is in the details. Such moves might show financial restraint, but they could also reduce your FICO Score. Your credit utilization ratio (your outstanding balances divided by your available credit) is one of the key factors in your FICO Score. Reduced credit limits and closed cards reduce the amount of credit you have available, which could lower your score. And if you've had the card for a long time, canceling it may lower the average age of your accounts, which will also ding your score.
Once again, no good deed goes unpunished. An individual who uses checks or debit cards to make timely payments will have less credit history than someone who consistently pays with credit. Less credit history could mean a lower FICO Score.
Aside from the impact on personal credit scores, one might also note that there's something inherently wrong with strong-arming people into using unnecessary debt just to establish credit history. Studies have repeatedly shown that people use cash more responsibly than credit. While more use of credit may have an upside for lenders, it can be dangerous for consumers.
To be fair, the base FICO model rewards many responsible consumer decisions. Paying your bills on time, not maxing out credit cards, and being responsible with different kinds of loans are all behaviors that the average consumer should practice. In the spirit of transparency, we should also mention that many lenders consider factors outside of the FICO Score when determining an individual's eligibility for a loan. However, the FICO Score is almost always a heavily weighted part of that analysis. If it's weighted more heavily than other relevant factors, then both consumers and businesses may miss out on opportunities. Until lenders adopt a different model, your best bet may be to maintain active lines of credit but use them sparingly.
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