Tuesday, February 9, 2010

How The New Credit Score Will Affect You

Lenders now have a second formula for judging your past, backed by the three giant credit bureaus.

Your VantageScore could look very different from your FICO score.

By Liz Pulliam Weston

The three credit bureaus are touting their new credit-scoring system as a boon for borrowers, easier to understand and more "consistent" than other scoring methods.

Maybe. But VantageScore, which uses the same underlying data about your debts as the FICO score you already know, also poses some serious risks.

Let's be clear: This isn't about making credit easier for the little guy. This is business.

Big business.

Equifax, Experian and TransUnion are private companies that each track your accounts, balances and payment habits.

A credit "score" simply assigns a weight to those factors to produce an indicator of how much risk you show as a borrower.

Fair Isaac's formula (FICO) for scoring is the one lenders like best.

Fico Scores/Reports

Every time an appliance store or car dealership asks one of the credit bureaus for your credit score, the data the bureau has collected about you is sent through the proprietary FICO model.

The lender pays the credit bureau for the score, and the bureau pays FICO for using its formula.

This is quite a lucrative business for Fair Isaac. Credit scoring accounts for 20% of the company's revenues, according to Merrill Lynch analyst Edward Maguire, but 65% of its operating profits.

The bureaus, naturally, want to cut out the middleman.

"They don't like having to pay Fair Isaac for anything,"

said mortgage broker Ginny Ferguson, who teaches credit scoring to her colleagues in the National Association of Mortgage Brokers. "The (credit bureaus) are intent on finding the next area of revenue generation."

The bureaus have tried to break Fair Isaac's stranglehold before, with no success. The VantageScore may be a different story.

Investors certainly think so; they drove Fair Isaac's stock down 6.6% on the day the new scoring system was announced, even though the bureaus hadn't signed up a single lender.

Analyst Maguire rightly called VantageScore "a shot across the bow" of the bureaus and opined that even if the new system didn't replace FICOs, the bureaus could use it as leverage to get Fair Isaac to lower its prices.

We wouldn't have to care about these elephants' battles, except that consumers may be the grass trampled under their feet.

Here are just some of the concerns:

1. Credit score confusion

FICO and VantageScore use two different ranges. The classic FICO scale runs from 300 to 850, while the VantageScore starts at 501 and runs to 990.

The bureaus say the VantageScore range is more "intuitive," because it breaks down like an elementary-school report card:

901-990 equals "A" credit

801-900 equals "B" credit

701-800 equals "C" credit

601-700 equals "D" credit

501-600 equals "F" credit

There will probably be a lot of puzzled borrowers trying to figure out why a number that would qualify them for the best rates and terms under one system - say, a 780 credit score - makes them credit mediocrities under the other system.

2. Consistency

The information in the credit-bureau databases can be wildly different.

You may have accounts reported at one bureau that don't show up at the other two, or you may have successfully disputed an error at two of the bureaus only to have the third refuse to erase the bogus entry.

One of FICO's big selling points for lenders has been the model's consistency.

Even though the bureaus collect and report credit information differently, the same basic FICO model is used at all three to generate comparable scores.

We shouldn't fall for the idea that the new system is superior without more evidence -- so far, VantageScore hasn't been tested head-to-head with FICO.

3. The good, the bad and the ugly -- but mostly the bad

VantageScore is being marketed to lenders as being a better way to separate "good" from "bad" risks including, to quote its Web site, "the ability to classify more bad accounts into the worst-scoring ranges."

Lenders, you see, are often less worried about losing out on good customers than they are about getting stuck with bad ones.

So if a few potentially good risks get wrongly qualified as bad, lenders aren't that worried as long as they avoid the deadbeats.

*** If you happen to be one of those good eggs who's paying higher interest rates or having trouble getting loans, though, you should worry.

Again, the bureaus are quick to say that they haven't tested VantageScore against FICO, so it's unclear whether the upstart actually does sweep more folks into the worst-scoring range.

But the fact that it's one of the bureaus' goals should help you understand the point: this is not about making consumers happier.

4. "Thin" and "Young" credit profiles

One of lenders' beefs about the classic FICO model is that people whose credit histories are "thin" (they have few accounts) or "young" (their oldest account has been established for only a few months or years) can still get pretty high scores.

The lenders grump that these borrowers may pose a greater risk than the scores predict, and that people should have more robust credit files before they reach the top of the FICO pyramid.

Once again, without comparing VantageScore directly to FICO, the bureaus are touting it as a better way to grade people with limited credit histories.

If that means the young or others without "robust" histories get better access to credit to buy homes and build businesses, this could be a good thing. If it means making credit harder to get for those folks, not so much.

5. High switching costs

To say that FICO scores are entrenched in the financial world would be understating the case.

"FICO scores are used by 80% of the 50 largest banks. They're used in 75% of the mortgage loan origination decisions," said Ron Totaro, Fair Isaac's general manager for global scoring solutions. "We're a force because we've been at this for 50 years."

It's not just the lenders that rely on FICO. Most loans today are bundled up and sold to investors, who use the scores to gauge how much risk they're taking with these investments.

Wall Street is comfortable that FICO-scored loans will behave as forecast, Ferguson said, but could be more nervous about the "predictiveness" of a new scoring system.

If lenders begin adopting VantageScores, they might tighten up their underwriting guidelines -- in other words, make credit harder for consumers to get -- while they see how well the loans actually perform.

*** Consumers can stand to reap some benefits from the new score.

For one thing, competition has a way of bringing prices down and forcing companies to improve their products.

But more importantly, the bureaus promise to provide clear guidance about what goes into the scores and how consumers can better their numbers.

How specific that guidance will be remains to be seen, but Kerry Williams, group president of Experian's Credit Services, said that he wants consumers to know exactly how certain actions can affect their scores.

Currently, Fair Isaac offers a FICO "simulator" through the my FICO.com website that can show you how a handful of actions might affect your score.

At the moment we can't buy our own VantageScores, but Experian promises to make them available to consumers in the next few weeks, and the other bureaus say they'll follow suit by the end of the year.

Then we'll have some more information to gauge whether VantageScores really are a better mousetrap -- or just more of the same.


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