FICO score
The FICO score is a widely recognized measure of credit risk, developed in 1989 by the Fair Isaac Corporation. It is a crucial tool that lenders use to assess the creditworthiness of potential borrowers, influencing decisions on whether to extend credit or loans and the interest rates to apply. The score ranges from 300 to 850, with higher scores indicating better creditworthiness; a score above 700 is generally considered good. Key factors influencing the FICO score include payment history, amounts owed, length of credit history, types of credit used, and new credit inquiries.
While the FICO score serves as a vital component in lending practices, it has faced criticism for its proprietary nature, potential inaccuracies, and perceived unfairness to certain demographic groups. The process of credit reporting has evolved over the years, particularly after the Fair Credit Reporting Act of 1971, which granted individuals the right to access and correct their credit information. Despite its criticisms, the FICO score remains an essential element of the credit system, aiming to facilitate equitable lending practices and efficient market operations. Understanding how the FICO score is calculated and its implications can help consumers navigate credit more effectively.
FICO score
Summary: A person’s FICO score helps lenders mathematically evaluate risk.
The FICO score is a standard measure for credit risk. It was developed in 1989 by the Fair Isaac Corporation (commonly referred to as FICO, which is also its ticker symbol), a public company (traded on the New York Stock Exchange) founded in 1956 and based in Minneapolis, Minnesota, and Equifax, one of three major U.S. credit reporting agencies. The FICO score is one of the chief ways lenders evaluate the credit risk posed by a consumer, using that information to decide whether to advance credit or a loan to them and, if so, how much interest to charge. Consumers judged to pose greater risk of default are generally charged higher interest rates to compensate for the high probability that they will not repay their debts. Models based on FICO scores are blamed in part for the housing crisis that occurred in the early twenty-first century. In the 1990s, subprime mortgage lenders began relying more on automated underwriting and quantitative models. These suggested that subprime borrowers were improving in terms of average FICO scores. This suggestion, coupled with the historical performance of subprime mortgage securities, was interpreted as a sign of strength in the subprime market, which proved not to be true.
Calculating the FICO Score
The formula for calculating the FICO score is proprietary and is regularly revised, but it can be described in general terms. The FICO score is calculated from data in a person’s credit report. The importance placed on the different categories of information varies but for an average customer the weights are approximately as follows: payment history is 35%, amounts owed is 30%, length of credit history is 15%, types of credit used is 10%, and new credit is 10%. FICO does not calculate the report itself; instead, when a lender requests a credit rating for an individual FICO, software is used by one of the three major national credit reporting agencies (Equifax, Experian, and TransUnion) to calculate the FICO score. These calculations may differ, since the three credit agencies often include different information. The score is therefore time dependent, and changes in a person’s financial and credit situation can be expected to result in changes to their FICO score as well.
The range of a FICO score is from 300 to 850, with higher scores denoting greater creditworthiness. The median score is about 725 and a score above 700 is considered good; a score above 770 generally qualifies people for the best credit rates. Scores lower than about 660 generally qualify people for only limited credit at much higher interest rates.
History of the FICO Score
The FICO score is a modern solution to a long-standing issue in business: managing the risk of lending money to an individual or business not personally known to the lender. Systems of credit reporting have been in existence for over 100 years and throughout their history, credit reporting systems have had to deal with the tension between lenders and merchants who wanted to protect their assets and consumers and businesses who wanted fair access to credit, which would help them expand their businesses or purchase major assets, such as a house. Credit reporting was largely unregulated until the 1960s, so there were no legal restrictions over what could be included (information about sexual preference and alcohol consumption were sometimes included, for instance) and individuals had no right to see what was in their records or to challenge incorrect information. Some criticize the FICO calculations, saying that the proprietary nature makes them unfair, they are inexact and poorly quantify risk for some subgroups of borrowers, information is not updated frequently, and the burden of correcting misinformation falls on the individual rather than the companies.
In 1971 Congress passed the Fair Credit Reporting Act (FCRA), which gave individuals the right to view their records and to dispute or correct any mistakes in their records. At the same time, credit reports began to include positive information (for instance, loans repaid on time) as well as negative information and, in 2001, consumers gained the right to see their credit scores rather than simply the information in their reports. The importance of the ability to view and to challenge information in one’s credit report was underlined in a 2004 study by the U.S. Public Interest Research Group, which found that 79% of credit reports have errors (usually outdated information or information that pertained to a different person), including about one-quarter with errors serious enough to justify the denial of credit. Although there are many criticisms of the process of computing credit scores, few would be willing to discontinue their use because they are an important tool for risk assessment, help ensure equitable treatment, and make the credit market more efficient.
Bibliography
Fair Isaac Corporation. “FICO.” http://www.fico.com.
Neal, Dana A. BestCredit: How to Win the Credit Game. 2nd ed. Boulder, CO: Paladin Press, 2006.
Wozniacka, Malgorzata, and Snigdha Sen. “Credit Scores: What You Should Know About Your Own.” http://www.pbs.org/wgbh/pages/frontline/shows/credit/more/scores.html.