If American consumers feel like they are back in school again, angling for a few more points and good grade, that’s no accident. The aggressive marketing of three-digit credit scores has practically turned a high figure into a status symbol – but it’s so much more than that.
Unlike that English 101 quiz, this grade can have a direct and severe impact on your everyday life. Credit scores now affect everything from car loans and mortgages to credit cards to auto insurance.
With the current credit crunch, scoring formulas are getting more scrutiny. Some lenders are even blaming the credit scores for the lending mess that is dragging the U.S. economy toward or into a recession.
Fair Isaac, maker of the original credit score, known as FICO, says a makeover is coming soon. Consumers’ scores will be affected when called FICO 08 is released, but it’s not yet clear how much.
Meanwhile, consumers are buying their credit scores from Web sites like never before. But despite their widespread availability, much about them remains shrouded in mystery, or distorted by credit score mythology.
On Tuesday we will examine the unintended consequences of that mystery – sleazy credit repair companies, confusion over what score is the “right” score, and the possible role that credit scores played in creating the housing bubble.
But before discussing the unseemly elements of credit scores, it’s important to understand what they are – and are not.
Credit scores essentially distill all the information from a credit report into a single number in an attempt to quantify the odds borrowers will repay loans on time.
They are relatively recent invention. The FICO score was invented by Minneapolis-based Fair Isaac Corp. in 1988 as an attempt to quantify the odds borrowers will repay loans on time. The company’s name is derived from those of Bill Fair and Earl Isaac, an engineer and a mathetician, who created the credit scoring concept and founded Fair Isaac in the 1950s.
That number is not, however, designed to paint a complete picture of someone’s financial life. More on that in a moment.
A secret sauce
Credit scores until recently were kept secret from consumers, along with credit reports. With the passage of the Fair and Accurate Credit Transaction Act of 2003, lenders were required to provide scores for free to consumers who apply for a mortgage, and credit bureaus were required to offer them for sale to consumers at any time.
The secret sauce behind the FICO score remains in the shadows. The formula must be a secret, the credit industry argues, because if everyone knew the exact steps to get a good score, all consumers would do those things, and the scores would become meaningless. In other words, the score would become nothing more than an indication of how well consumers could “game” the system rather than their ability to repay loans.
Fair Isaac has on its Web site a diagram of what goes into a credit score and what doesn't. Every consumer should see the pie chart on this page. Boiled down, two factors account for most of a credit score, says said Lisa Nelson, vice president of global scoring for Fair Isaac: “Pay your bills on time, and don’t max out your credit cards.”
About 85 percent of the population has credit scores in the 500-800 range. Each lender uses different criteria, so it's hard to make sweeping statements, but here's how the system generally works:
If your score is over 720, you are golden. According to Fair Isaac, about 60 percent of the population has a score that's above 700, making them eligible for most banks' best rates.
If it’s in the 600s, the action heats up. A few points here and there can make a huge difference. In fact, one point can make that difference. On Fair Isaac's loan calculator, a consumer with a 674 credit score will pay interest on a mortgage that is a full point higher than someone with a 675. On a $500,000 mortgage, the difference is $400 each month, or $150,000 over the life of the loan.
Sink into the low 600s, and the difference is astronomical. A person with a 619 credit score would pay double the interest rate of someone with a 720. The added interest would cost the former an extra $750,000 over the life of the loan.
A 100-point credit score drop could be the most important and detrimental event of a consumers' life, even worse than losing a job.
Income doesn't count
While mathematics doesn’t discriminate, scores do. Credit scores, for example, take no account of a consumer’s job or income -- something lenders call "capacity" to pay. Assets don’t count, either. They are not intended to be a broad picture of someone’s financial life, just a prediction of the likelihood that the person will repay a loan on time, based on past payments.
Because they also don’t take into account for the kind of loan someone is seeking – whether a $10,000 car loan or a $500,000 adjustable rate mortgage on a home -- they provide only limited information to for banks to consider.
Still, many lenders rely heavily -- or even exclusively -- on scores, leading to some crazy discrepancies.
“I assist millionaires that can't get a credit card and 20-year-old kids that have a $200,000 mortgage,” said Katherine Gregory, who runs Credit Resources Group, a firm that helps consumers improve their credit scores.
Making credit scores available to the public was supposed to clear up some of the confusion about the figures. But in some ways, it made matters worse.
Not all credit scores are the same. Consumers usually buy their credit scores from the credit bureaus, but when they do they are buying a product called a VantageScore, not the FICO score from Fair Isaac that most lenders use. And some lenders sometimes create their own variation on a FICO score, adding in their own criteria.
Credit bureaus deserve some of the blame for the confusion. Experian's FreeCreditReport.com, which also offers consumers a peek at their credit score when they pay for a monthly service, boasts it has 20 million customers. But the scores that Experian’s customers see may differ greatly from their FICO score.
That’s why Fair Isaac has sued the nation's three credit bureaus, alleging they are "misleading and confusing consumers" when selling their own version of the credit score.
There may be light at the end of the tunnel, however. The housing market collapse means that scores will likely lose at least bit of their influence in lending decisions. That could blunt our nation's ever growing obsession with credit scores, and that's a good thing for anyone who doesn't like being treated like a number. Still, great perils abound.
Next week, we’ll look at the possible role of credit scores in the housing market collapse, and hear that even those who created the score believe it’s overused. We’ll also look at ways you can improve your score, and the myths that will accomplish nothing.
Editor's note: A prior version of this column indicated credit scores were not widely available before 2003. Credit scores were made available for consumers as early as 2001, according to Fair Isaac. MSNBC.com regrets the error.
