There has been a lot of press surrounding the release of Fair Isaac’s new credit scoring system, FICO 08, and in my opinion the new FICO has been overhyped. Nevertheless, both consumers and creditors should be glad to have it since it is a marginal improvement in the critical area of credit risk analysis.
The benefit of an improvement in this area must be understood in light of the credit industry’s reliance on the shared responsibility of all borrowers. In such a system, even the most responsible borrower suffers due to flagrantly irresponsible behavior by others. Wide spread credit problems, then, have a disastrous effect for all borrowers—those who pay their bills on time as well as those who don’t. Right now, the general condition of credit throughout America is hurt by the awarding of loans to individuals who can’t pay them back. Any improvement in this area will better separate people who are good credit risks from bad so that banks can do better in distinguishing who should get a loan. Ultimately, this leads to fewer losses for the banks and allows them to pass savings on to borrowers who are reliable.
That being said, the hype that surrounds the FICO 08 is undeserved. It promises a 5-15% lift in predictive performance, according to Fair Isaac, which is not that impressive for a new model. Obviously, FICO 08 is Fair Isaac’s new product and much of the news we’re hearing about it is part of the PR campaign to make the new score attractive. In my opinion, the most important thing about the FICO 08 is not its improved predictive performance but rather the use of more intuitive methods when calculating a credit score.
First, previous versions of FICO based their scores on the extreme worst performance in a borrower’s history. Because of this, one minor mishap with payments could effectively destroy someone’s credit. The FICO 08 looks at a person’s entire credit history to create a more holistic view by weighing both their good and bad behavior. It doesn’t put too much emphasis on one problem.
The FICO 08 also ignores credit problems of less than $100 value so that unpaid parking tickets and library fines will not hurt a person’s credit score.
Lastly, the FICO 08 system directly addresses the problem of authorized user abuse that is now a serious problem within the credit industry. More specifically, A borrower was able to artificially boost their credit score by paying a stranger with better credit to be an authorized user on the “strangers” credit card. FICO 08’s new procedure, in preventing this practice, stops a black market industry that has been allowing people to take out loans for which they would not, otherwise, qualify.
The process FICO 08 uses to determine credit scores is now based on more intuitive factors than the previous FICO. These changes are far more deserving of industry attention than the 5-15% lift in predictive performance with the most noticeable changes happening at credit scores of 650 and below. Our advice to consumers, given the changes in the scoring system made by FICO 08, is simple: There is nothing to worry about. As always, try to be as responsible as possible with your credit obligations and check your credit report once a year at annualcreditreport.com for any errors. Overall, we should always be happy if we get a more accurate and more intuitive credit risk model because it minimizes the chance that a bank will extend undeserved credit to irresponsible borrower. FICO 08 is a marginal improvement towards that direction.