What started out as Fair, Isaac and Company, FICO, the analytics company and their omnipotent FICO Score has come to dominate many parts of our life.

  • Want a mortgage? FICO.
  • How about a car loan? FICO.
  • Maybe refinance that student debt? FICO.

The list goes on and on. But what exactly is a FICO Score, where do they come from and more importantly, do they actually work?  Numerous other factors have been proven to influence a person’s ability to repay a loan better than FICO Scores, but they’re still industry standard. Obviously, there must be more than meets the eye.

What is FICO and a FICO “Score”?

In the world of all things credit related, you’ve probably heard the two syllable word FICO at some point. A FICO score is the branded name of a three-digit credit score that is used by most of the nation’s largest financial institutions to make credit and loan approval decisions.

In fact, 90% of all lending decisions in the United States are predicated on this FICO score. As lenders want a fast and consistent method of deciding a borrowers credit worthiness.

Many factors are taken into account to arrive at a FICO score

FICO scores are essentially a comprehensive summary of your credit report. The number is derived by: payment history (35%), amounts owed (30%), length of credit history (15%), type of credit (10%), and new credit (10%)

In addition to helping lenders make informed and quicker decisions, it also provides quick and relatively fair access to credit when needed. As FICO scores fluctuate on your credit activity, you have the ability to influence the score by making payments on time, not taking on too much debt, and opening new accounts.

Why Are FICO Scores Important?

FICO Scores help millions of people gain access to the credit to get education, buy a home, or cover medical expenses. A good FICO Score will save you thousands in interest and fees as lenders are inclined to offer lower rates as you present less of a risk for them. Increased accessibility to credit allows lenders to make more loans which drive costs as the process becomes more efficient.

The History of  Credit Scores

It Began In The 1800s

In the 1800’s, credit was initially used for businesses, not consumers. With the rise of business transactions, commercial lenders needed to figure out how to standardize credit evaluation. In 1841, the Mercantile Agency gathered information from people around the country to establish the profile of a borrower’s “character and assets”. Data gathered proved to be very biased around race, class, and gender. Subscribers of both the Mercantile Agency (renamed R.G. Dun & Co) and its rival, the Bradstreet Company, pushed for a simplified evaluation method. The two companies would subsequently merge into dun & bradstreet and create an alphanumeric system for credit evaluation.

1900’s Credit Changes

As household income increased and saw the birth of a middle class, the credit-reporting sector understood the need to develop a system to evaluate consumers in addition to businesses. Atlanta’s Retail Credit Company (RCC) began collecting data on millions of Americans, but as the company expressed plans to computerize said data, the government blocked their efforts.

The Fair Credit Reporting Act

In 1970, the Fair Credit Reporting Act (FCRA) was passed requiring credit reporting bureaus (like RCC) to make their files public; expunge data on race, sexuality and disability; and delete negative information after a specified period of time. The company would ultimately change its name to Equifax in 1975. Shortly thereafter, Experian and TransUnion came along and are considered the top three credit reporting agencies.

FICO Scores in 1989

Despite a demand for the services of the three credit reporting agencies, there was still difficulty synthesizing their reports. The three agencies began working with a tech company founded in 1956, called Fair, Isaac, and Company aka FICO to develop an industry standard scoring algorithm. This algorithm ultimately became the FICO Score and is still used today.

FICO Today

In 2014, FICO announced that it would stop including any record of a consumer failing to a pay bill if the bill has been paid or settled with a collection agency. The changes boosted consumer lending, especially borrowers who were excluded from the market or charged high interest rates because of their low scores.

This year, FICO updated how it treats personal loans. If you pay off all your credit cards with a personal loan, under the old system, your credit score might go up. Under the new approach, FICO will look back over the past two years to see whether you’ve used the loan to reduce high-interest credit card debt or whether you’re using plastic as much as before, running up new revolving balances and falling deeper into debt.

Okay… but Does FICO Even Work?

Over 200 million Americans have scores, but in order to have a score, you need an account that submits to a credit reporting agency (like a credit card, mortgage or auto loan). You also need to show activity on that account i.e. have a balance. Many believe that paying interest coincides with a good credit score. However, paying off the entire balance every month is sufficient.

However, 53 million people not do not have FICO scores as they do not have active accounts that report to a bureau. This is where credit scoring gets a lot of its pushback. Many of these individuals use debit cards to make purchases, pay bills on time, and have healthy savings accounts. But the lack of a credit score can make qualifying for a mortgage or auto loan impossible.

Furthermore, requiring individuals to open credit cards to get a score can promote poor habits. It has been psychologically proven that people spend less money when using cash. Unfortunately, the quickest path to achieving a good credit score is through the use of a credit card. This often leads to people spending more than they originally planned.

Beyond FICO

There are numerous online lending platforms and other financial companies that have created their own ratings and revolutionizing the personal loan space, as well as the online investment space by allowing individuals to purchase blocks of loans from their customers.

  • Prosper: a website where individuals can either invest in personal loans or request to borrow money.
  • Fundrise: labeled as the first company to successfully crowdfund investment into the real estate market, they provide potential investors with an array of insights, not only the lender’s FICO Score.
  • AM Money: a student loan company that offers a healthier approach to financing higher education.
  • LendingClub: an American peer-to-peer lending company, headquartered in San Francisco, CA, which was the first to register its offerings as securities with the SEC and offer loan trading on a secondary market.

On a totally unrelated note with global impacts… Check out our recent post about the coronavirus outbreak and its impact on the global economy.

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