FICO, founded in 1956, pioneered credit scoring in the United States and the world. Today, FICO continues to be used in 90% of credit decisions in America. However, FICO’s dominance is under threat. In November, VantageScore announced that more than six billion VantageScore credit scores were used in the past twelve months, an increase of 100 percent over the previous twelve month period. FICO’s grip on the American scoring psyche has never looked more tenuous.
The credit scoring landscape is changing as a result of three key trends:
- Creating a credit score for “thick file” consumers is becoming highly commoditized
- Pressure to score “credit invisibles” has never been greater
- The 2008 financial crisis revealed the danger of an over-reliance on scoring models
However, FICO will be able to maintain an outsized dominance so long as Fannie Mae and Freddie Mac require FICO to be used in all mortgage lending decisions. But even that could change.
Credit Scores Are Commodities
When the first credit score was created by FICO, it was truly revolutionary. Bank executives around the world had to be convinced that a scoring algorithm would be a better judge of credit risk than human judgment. The data was overwhelming, but it took time. Eventually, the strength of the data convinced bank managers globally that scoring algorithms, when used properly, provided superior results to judgmental and decentralized underwriting.
However, like all innovations, the secret sauce of the FICO score can be copied. FICO has disclosed publicly, in general terms, how its score is calculated. The statistical methods used to develop the score have become industry best practices, but are no longer secret. In fact, most banks have their own team of statisticians building custom scoring models, using the same techniques and rigors as FICO. Many banks even have former FICO employees working for them.
In order to have a FICO credit score, you need at least six months of credit history. But once sufficient data is available, building a robust credit score has become highly commoditized. There are many businesses overseas that will build scoring models for banks at a fraction of the price, using the same techniques employed by FICO statisticians.
Perhaps the biggest attack is coming from VantageScore, an independent company that was developed by America’s three credit reporting agencies. Equifax, Experian and TransUnion teamed up to create an alternative to FICO, which is called the VantageScore. If you have an account with CreditKarma, you are receiving your VantageScore, not your FICO. And if you compare your VantageScore to your FICO, you will notice that it is remarkably similar. For thick file consumers, differences between scoring models are marginal. True market competition has arrived for generic credit scores.
Credit Invisibles Can No Longer Be Ignored
26 million Americans are credit invisible, according to the CFPB. That means they have no information on their credit reports. An additional 19 million consumers do not have enough information in their credit reports to receive a credit score. Without a credit score, access to affordable credit can be limited.
Not having a credit history does not mean you are not creditworthy. A disciple of Dave Ramsey, with a fully funded emergency savings account, a paid off mortgage and regular debit card usage is a creditworthy individual. However, FICO (and other traditional scores) only work well on “thick file” consumers. The race is now on to find ways to build scoring models for previously un-scored individuals. FICO is launching FICO XD (explained here), which will use utility and mobile phone data to score individuals. VantageScore, with its 3.0 model, “has the ability to formulate a more consistent score for 30 – 35 million previously unscoreable customers.” In addition, many Silicon Valley companies are trying to leverage alternative data sources to generate scores. The race is on to score credit invisibles, and the winner is not yet clear.
2008 Financial Crisis Revealed The Limitations Of Models
Before the financial crisis, far too many lenders relied almost exclusively upon scoring models and left common sense at the door. Credit scoring models are helpful tools, but should not be the only tool when making big underwriting decisions. For many mortgages in particular, income was no longer verified. Cash flow was no longer analyzed, and down payments were no longer required. If you had an excellent credit score, you could get whatever you wanted.
The pendulum clearly swung too far before 2008, and it is now swinging in the other direction. Many of the marketplace lenders are now putting cash flow underwriting front and center. Regardless of your credit score, you need to prove that you can afford to make the payments on time each month. Some lenders are publicly abandoning FICO, given that it punishes responsible millennials who avoid debt and does not take into account cash flow. This public change in sentiment can leave traditional credit scoring companies feeling vulnerable.
The Power Is With Fannie Mae And Freddie Mac
FICO created a revolutionary way to make credit decisions, and its approach is being used all over the world. However, its continued dominance in the US is largely the result of Fannie Mae and Freddie Mac using FICO. So long as the biggest, deepest credit market in the world requires a FICO, the score will remain dominant.
VantageScore is working hard to gain acceptance with the agencies. Both enterprises are examining the use of this FICO alternative. Progress is slow, but technically a decision could come as early as Q1 2016, according to Jeff Richardson of VantageScore. Regardless of how long it takes, competition is coming to the mortgage market, and the dominance of a single credit score may not last for much longer.
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