Is the FICO Not a Good Measure of Risk?

The Fair Isaac Corp., or FICO, first developed a formula for assessing credit risk during the 1950s, and the three national credit rating agencies: Equifax, Experian and TransUnion, all use credit scoring based on the FICO model. However, FICO scoring models rely on historic data, and some argue that you should not rely on FICO scores alone when measuring risk.

Basics

The credit scoring models used by all three national credit bureaus have certain similarities, such as the fact that credit scores in excess of 750 are viewed as good and scores below 620 are seen as poor or subprime. However, each bureau uses its own scoring model, so given that the firms rely on the same data you would think that the scoring models would look identical. In fact, one credit bureau may give you a much higher score than another due to the differences in how scores are calculated. Therefore, you may or may not qualify for a loan depending on which bureau's risk model your lender decides to use on the day that you submit your loan application.

History Versus Future

Credit scores are based on historic data related to your management of your credit accounts. FICO advocates believe that your past credit management habits are indicative of your future actions. However, you may have an excellent credit score but if you lose your job due to ill health or a layoff, you may suddenly have to stop paying your bills due to a loss of income. When home prices plummet due to external economic factors, people with good credit sometimes choose to let their home fall into default rather than keep paying on a loan that exceeds the property value. FICO scoring models have no way of predicting these actions and events.

Manipulation

You do not have a credit score until you have established credit and you cannot usually obtain credit until you have a credit score. This conundrum leads many people to ask relatives with good credit to co-sign on credit cards or loans as lenders approve the loan on the basis of the co-applicant's credit. However, the failure of the primary borrower to honor the debt has an adverse impact on the co-applicant's otherwise impeccable credit. Likewise, someone can rapidly build a good credit score by becoming a co-signer on a credit card owned by someone with established credit. In these situations, other people's actions can improve your credit or hurt it and the FICO score you are left with does not necessarily reflect your true credit managing capabilities.

Considerations

FICO scores have major limitations but can work well as a risk assessment tool if used in conjunction with other data, such as income verification from loan applicants. A high credit score might suggest someone has high income, but unless you verify their income, you have no way of knowing whether that person has no income at all and just uses one credit account to pay down another. However, if lenders look at a borrower's credit history along with their bank accounts, tax returns and other financial information, then FICO scores are a good tool as part of the overall risk management process.