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October 14, 2009

New FICO scoring model may do more harm than good


New changes to the FICO® credit scoring model, dubbed FICO® 08, were recently made available to all three major credit bureaus (Experian, Equifax and TransUnion). While some are touting these changes as a win for consumers, Lexington Law®, a consumer advocacy law firm, cautions that FICO® 08 may instead cause millions of credit scores to decline.
Used by lenders to assess credit risk, credit scores are derived through statistical analysis of the information in a credit report. The FICO® scoring model translates this data into a single 3-digit number ranging from 300-850. Lenders use this number to determine whether a borrower is likely to repay his or her debts.

This new scoring model has received positive publicity because it excludes minor missed payments from negatively affecting credit scores. The model docks fewer points from credit scores for charged-off accounts of less than $100 and for isolated 30-day late accounts.

Some, however, believe that FICO® 08's scoring model does little for consumers.

"The industry is hyping FICO® 08 as a great thing for consumers because of the way the new scoring model reports some late payments" says John Heath, directing attorney for Lexington Law Firm, "However, no one has blown the whistle about how few consumers will benefit from the new model and how small of a benefit those few will actually receive."

"After all, isolated late payments and small accounts don't represent the bulk of the negative items found in consumer credit reports; a large number of collection accounts are for far more than the $100 threshold FICO® 08 uses. Additionally, those few consumers who have these types of mildly delinquent accounts may not see any scoring increase, because the prior scoring model already considered that a collection account might be isolated and for only a small amount."

A potentially more significant change, that has incidentally already received some negative publicity, is the increased weight placed upon credit utilization: FICO® 08 is more sensitive to the percentage of available credit consumers are currently using. This change will likely affect millions of Americans who carry higher or even maxed-out credit card balances. Those Americans may experience immediate reductions in their credit scores.

Recent economic conditions, during which credit card companies have reduced credit limits or canceled cards outright, has compounded this problem for consumers. FICO® 08's increased emphasis upon credit utilization means that consumers whose credit limits were reduced are more likely to experience greater credit scores reductions than they would have seen under the previous scoring model. Simply put, with the new scoring model, lenders are far more likely to view consumers who have had their credit card limits reduced as greater lending risks.

"Credit utilization ratios have a place in the credit scoring model, but to place more emphasis on this factor in today's economy is problematic," added Heath. "With today's strict lending requirements, even some very creditworthy consumers must pay higher interest rates because of their credit scores, resulting in higher profits for credit card companies and other lenders. With FICO® 08, credit card companies have more power over consumer credit scores. They can lower their customers' credit scores by simply reducing their credit limits."

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