Changes to Fair Isaac's Credit Scoring Model
Written by: Kristy Welsh
Last Updated: September 25, 2017
FICO, which began as Fair Isaac and Company, was founded by engineer Bill Fair and mathematician Earl Isaac in 1956 to help department stores and gas stations decide when to extend in-house credit cards to customers. They sold their first credit scoring system two years later and then in 1967 FICO became a publicly traded company. The company was renamed in 2003 to Fair Isaac Corporation and then in 2009, rebranded itself as FICO. But what really is a FICO Score and how has it evolved since 1956? Let's take a look.
What is a FICO Score?
Since the creation of the first credit scoring model, FICO has become the benchmark of credit scoring used and copied by hundreds of other companies trying to break into the credit scoring market. FICO itself does offer many different types of scores that are customized for different industries, such as mortgages, auto loans, insurance, but they all use basically the same information to come up with a three digit score. This score is a number assigned to a consumer that attempts to summarize whether that person is worthy of receiving credit. Mortgage lenders, credit card issuers, car dealers and other lending businesses rely on credit scores to decide whether to extend credit, and if so, how much to charge in the form of interest.
The information used to come up with a FICO score is as follows:
- Consumers' history of paying their debts on time.
- How much of their available credit have they used.
- How many different types of credit are they using.
- Do they have a history of unpaid debts.
Using all of this information, the mathematical algorithm spits out a number, between 300 and 850, which predicts whether or not a person will pay their debts in the future. The higher the score, the more likely they are to pay their debts and they are considered to be a "low risk" borrower. The lower the score, the more likely they are to default on their loans, pay their debts late, or file bankruptcy, and these people are considered to be a "high risk" borrower.
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Changes in FICO Over the Years
Since it's first release, there have been minor updates to the FICO score algorithm every two to three years just to keep up with the changing economic environment and consumer behaviors. It was not until early 2009 that FICO released FICO 8 which, according to FICO spokesman Jason Sprenger, "allowed FICO scientists for the first time to break the blueprint of our original FICO scoring algorithm and create a segmentation that rendered significantly more predictive credit scores than was possible before."
So, what prompted this radical overhaul of the classic FICO scoring model? The financial crash of 2008 prompted many consumers to drastically reduce their credit card debt which in turn affected the overall average credit utilization ratios. Also, studies found that a lot of people had medical debts that were erroneous which caused late payments and collections to appear more frequently in credit files.
FICO 8 — What Has Changed?
A demand by users for a better way of analyzing risk in the wake of rising mortgage defaults and consumer credit delinquencies was the catalyst for Fair Isaac Company to release FICO 8. Here are just some of the improvements:
- A moderate level of credit inquiries will be less detrimental.
- High balances on existing credit cards may hurt your score more than before.
- Authorized user loopholes will not be allowed.
- Actively utilizing existing credit accounts will increase in importance.
- A combination of installment and revolving credit accounts will be optimal.
- The new model divides consumers into 16 categories, not the 10 as in the previous version, thus helping lenders fine-tune credit decisions.
- FICO 8 goes easier on people who have missed payments on small debts under $100, which are often erroneous medical debts.
Is FICO 8 Being Used by All Lenders?
Since it's release in early 2009, the answer to that question is "no." As one journalist put it; "Big ships don't spin on a dime." Large banks and lenders have not embraced the new scoring model due to the enormous cost of implementing a new program into their lending practices. In the case of Freddie Mac and Fannie Mae, the largest user of FICO scores, they have bigger fish to fry in the wake of the real estate bubble bursting. They are just trying to stay afloat and have no budget or desire to implement the new scoring model at this time.
FICO did issue a press release back in June of 2011 touting the fact Citibank had implemented the new scoring model. Having made such a big deal about this makes one scratch their head and wonder, "is this the only bank to have made the switch?" What happened to Chase, Bank of America and Wells Fargo? According to a spokeswoman for Bank of America; "We're in the process of implementing the new scoring model but I wouldn't have any more details to share." Wow — talk about vague!
Future of FICO 8
If FICO 8 can help millions of people with small delinquencies improve their credit and help lenders make better decisions, it is a shame it has not been more widely implemented as of yet. The mortgage industry is still reeling from the real estate market bust and a lot of lenders simply feel that if the scoring model is not broken, why fix it.
Even though implementation of FICO 8 is going very slowly — we are now going on 8 years since the release — more and more lenders are starting to adapt it. But will it really make that big of a difference to consumers? That is still yet to be seen. Until the scoring model is used and accepted in the mortgage industry, it's impact will be pretty nonexistent.
In the meantime, consumers need to concentrate on cleaning up their credit, paying their bills on time, and getting out of debt. That way, no matter what scoring model is being used their scores will be higher.