Jeffrey P. Hulett
‘Odds of loss’ usefull
The interest rate on a mortgage or home equity loan, the car loan from the dealer-lender partnership and – potentially in the Bay State – even how high an auto insurance payment is going to be all depend on one major factor: a consumer’s credit score.
That’s why planned changes to Fair Isaac Corp.’s 18-year-old credit-scoring system will have such far-reaching effect, Massachusetts lenders and consumer advocates say.
Fair Isaac tweaks its FICO scoring system every couple of years or so to keep it in line with current consumer credit habits. Local lenders, however, haven’t heard much about the latest series of changes, which are slated to take effect in September.
But any change is going to have an effect, predicted Gordon Edmonds, president and chief executive officer of Leominster Credit Union. On auto loans, he said, a change “could impact whether a loan request is approved or denied, or the price that the consumer will have to pay.”
On mortgage loans, including those underwritten by Fannie Mae or Freddie Mac, credit scoring also is a factor in price; in the case of low credit scores, it also determines whether the government-sponsored entities will back a mortgage at all.
Fair Isaac plans two major changes to its benchmark rating system, which since its inception has generated $100 billion in revenue for the credit-rating agencies Experian, TransUnion and Equifax that sell scores to lenders and consumers.
First, the scoring system will no longer allow additional authorized users of credit cards to be affected by the primary user’s credit history, because it was discovered that some primary cardholders were selling their good payment histories to borrowers who wanted to improve their credit scores that way. An authorized user, typically a spouse or child of the primary cardholder, is not responsible for paying the bills but previously benefited or suffered score penalties based on the cardholder’s credit history. According to Fair Isaac, between 25 percent and 30 percent of credit card users have authorized secondary users of their cards. The company said that because of the chance, about 1 percent of consumers it tracks will no longer have any credit history when the new rules are implemented.
Perhaps more significantly, Fair Isaac also will change the way it divides the U.S. population by credit risk. The expanded system will include more segments overall, and more that focus on borrowers with deeper credit problems.
Fair Isaac spokesman Craig Watts said the rating system currently divides the nation’s 165 million FICO-scored borrowers into 10 credit-worthiness segments, two for people with significant credit problems and the rest for those with better credit. Under the new scoring formula – which will be introduced by Experian next month and rolled out by the other two major credit bureaus, TransUnion and Equifax, next year – there will be 12 segments, with four devoted to people with credit blemishes.
“The [new] score is significantly more accurate, by 5 [percent] to 15 percent, for certain populations of consumers,” Watts said. Lenders will get the most risk-related information about consumers who fall into several main categories, including a “high risk” group and “thin file” consumers who have established little credit history.
“Based on the newer scores, they might want to change the cutoff points for an auto loan,” Watts said.
Watts would not elaborate on specifics regarding the new categories and said creditors will not actually see the breakout of categories, which are at the core of Fair Isaac’s proprietary system. The categories, however, are key factors that are used in providing potential lenders with statistical assessments of risk – or in other words, establishing models that predict the likelihood a borrower will default on a loan.
Credit scores range from 300 for consumers who present the greatest amount of risk to 850 for those who are considered to be the least risky. Some consumers will see their credit scores rise under the new system, while others may see scores drop, Watts said.
“The main things everyone should do are pay their bills on time without exception, including parking tickets and library fines,” he said, because you never know who’s submitting the information to credit bureaus. Borrowers also should try to keep credit card balances low, and only take on new credit when they really need it.
Debt payment history counts for 35 percent of a FICO score, and is weighted more heavily to reflect recent payments. The total amount of debt a consumer holds accounts for another 30 percent of the score, and the length of time during which a consumer has been establishing credit accounts for another 15 percent (longer credit histories are better). Another 10 percent of the score is affected by how many times the borrower sought out new credit in the months before applying for the current loan, and the final 10 percent is an analysis of the number and type of outstanding loans the borrower currently has.
Deirdre Cummings, legislative director for MassPIRG, the local affiliate of the national consumer advocacy group, said a driver’s credit score could affect the auto insurance rate he or she will get under regulations the state Division of Insurance is considering.
“If [auto insurers] can use credit scores, consumers with better scores will get better rates,” she said. MassPIRG and the National Consumer Law Center have argued against the practice, and an NCLC report released in July summarizes “the many studies indicating enormous racial disparities” created by the use of credit scores in insurance decisions.
‘Significant’ Changes
David Floreen, senior vice president for government affairs at the Massachusetts Bankers Association, said mortgages, home-equity loans and some small-business loans also are dependent on credit scores.
In particular, larger, high-volume banks such as Bank of America, Citizens, Sovereign and TD Banknorth rely heavily on FICO scores in many loan decisions, he added.
Jeffrey P. Hulett, director of marketing, strategy and analysis at $3 billion-asset Rockland Trust, said he’d be surprised if any bank doesn’t use the score. Watts said Fair Isaac found that 91 of the nation’s 100 largest banks include a FICO score in their credit decisions and 75 percent of residential mortgage loan decisions consider FICO scores.
Some lenders or insurers use their own scoring models, and some use scores provided by other credit bureaus’ proprietary systems, Cummings noted, calling it “a roll of the dice” as to which score a lender or insurer will actually consider, or weight more heavily.
She also said at least 25 percent of consumer credit reports contain errors, which, she said, calls into question the accuracy of some scores.
Hulett said that bankers consider FICO scores important for the “odds of loss” they help predict. Fair Isaac provides lenders with charts to help determine those odds, based on borrower scores, he said.
Hulett and Edmonds both said their institutions consider other factors besides a credit score when making credit decisions, including a potential borrower’s history of paying off debt, his or her income and loan-to-value ratios.
Watts said Fair Isaac believes its new credit scoring method will help lenders assess risk more accurately.
“We do see this as a big deal,” he said, even though just a few people in lender risk-management departments seem to have heard of it to date.
“This time,” Watts said, “the changes to the [credit scoring] formula are more significant.”
