Keeping Score

Phil Kernen

WHAT’S YOUR CREDIT score? That’s hard to answer because none of us has just one. You likely have a dozen or more. So how did consumers come to think that one credit score—the FICO score—is the sole reflection of their ability to repay a loan?

Following decades of growing consumer spending, and associated data collection, the Fair Credit Reporting Act of 1970 required credit bureaus to open their files. The intent was to protect consumers from lenders who were relying on incorrect information. The law allowed everyday Americans to review their data for errors, while also requiring credit bureaus to delete unrelated information.

Accuracy was important because consumers were increasingly using borrowed money to pay for purchases. Credit bureaus, however, were still struggling to find an industry-standard credit score which lenders could apply consistently. Enter the Fair Isaac Corp. It developed the FICO credit score in the late 1980s. Using data from the credit bureaus, its proprietary models applied a weight to each input to calculate a score.

Fair Isaac disclosed a general outline of the information it used to compute its score. The finer points of FICO methodology are still shrouded in mystery, however, and subject to change at its discretion. In the 1990s, my wife worked in a consumer credit organization that utilized FICO scores. She saw firsthand that the secrecy surrounding Fair Isaac’s methodology led many to simply take the scores on faith and accept that they accurately reflected a consumer’s creditworthiness.

With little competition at first, Fair Isaac enjoyed a near-lock on the sale of credit scores. By 2006, to reduce costs, the three largest credit bureaus combined to develop and introduce their alternative model, VantageScore. Depending on the purpose, lenders often rely on both sources, but FICO remains the industry leader.

The pandemic is changing the credit scoring landscape further still. The Wall Street Journal recently reported that FICO scores are becoming a smaller factor in underwriting decisions. Instead, many banks and other lenders have begun using internally generated scores. These are based on a wealth of new data available to predict who will pay and who won’t. Currently, there are no requirements to share these internally generated scores with consumers.

Creating scores internally saves on fees. More important, it leads to faster credit decisions and allows lenders to assess borrowers with brief or nonexistent credit histories. For example, FICO scores don’t reflect loan deferment and forbearance programs, making it harder for lenders to evaluate some borrowers. Also, more than 50 million Americans lack a FICO score because they have thin or nonexistent borrowing histories.

For consumers, the rules haven’t changed: Higher scores are better. Using credit responsibly will lead to higher scores, regardless of which credit scoring model is employed. But getting rid of errors can also raise scores. One reason for the multiple credit scores for each of us is a lack of data consistency.

Lenders share their data with credit bureaus, but not uniformly. One bureau may show a collection account while another does not. The bureaus are competitors, so they don’t share information. Also, credit bureaus and financial institutions make reporting mistakes.

That’s why it’s important to review our reports with the three largest credit bureaus: Equifax, Experian and TransUnion. We’re entitled to a free copy of our credit report from each one every 12 months. Keeping them complete and accurate reduces the risk that an undeserved score might hurt our creditworthiness.

Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. Check out his earlier articles.

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