A Brief History of FICO: How Traditional Credit Metrics Fail Prime Borrowers

Most lenders today rely almost exclusively on consumer credit scores, predominately FICO, to determine a borrower's credit risk.  The reason for this is not because FICO scores are a particularly good predictor of credit risk, but rather because the mortgage market irrationally subscribes to FICO.  This irrational behavior has its roots with the usual suspects: Fannie Mae and Freddie Mac.  Through Fannie and Freddie, the US Treasury will only guarantee "conforming loans".  The definition of "conforming" is where the over-reliance on FICO originates: only mortgages originated to borrowers with FICO scores of at least 620, and usually 640, qualify as conforming loans.  This bright line delineates the traditional "prime" and "sub-prime" segments of the consumer loan market.  This artificial credit delineation can cause massive disruptions in the mortgage market (as it did in 2008).  However, Fannie and Freddie's religious adherence to FICO make it impossible to overcome: 50% of the mortgage market or 45% of the entire consumer loan market are conforming loans.   


Over-reliance on FICO scores disproportionately affects Prime student loan borrowers.  The exact formula for calculating FICO scores is secret, but the credit bureaus publish rough guidelines:

• 35% Payment history: positive for successful payment history, negative for delinquencies
• 30% Credit utilization: ratio of revolving debt to available credit
• 15% Length of credit history: longer credit history is unconditionally positive
• 10% Types of credit used (student loans, credit cards, mortgages, auto loans, etc.): more types of credit are unconditionally positive 
• 10% Recent searches for credit

It should be readily apparent that a Prime borrower - a recent college graduate who is gainfully employed - would be universally hurt by 90% of these scoring criteria (bolded).  A recent graduate has no payment history outside of minor credit card debt - a negative value for 50% of the scoring rubric.  A recent graduate will likely have a low credit limit because, incestuously, credit limits are determined by FICO score! So, a recent college graduate making $250,000 a year will likely have a lower credit card limit than a 60 year old on social security.  Additionally, post-Financial Crisis credit limits have contracted substantially, so the average Prime borrower today has a much lower credit limit than what has been the historical average.  As a result, today's Prime borrower has a much higher "credit utilization" ratio than the historical average, a negative for 30% of the FICO score.  Notably, this metric doesn't take into account more traditional ratios, such as total income to revolving debt, but focuses exclusively on liquidity.  So our Prime borrower with $250,000 in annual income and $1,000 in credit card debt with a limit of $2,000 (the average) would be heavily penalized for a high utilization rate despite an income to debt ratio of 250:1.  Finally, a Prime borrower likely only has two types of loans: student loans and credit cards.  Very few students have mortgages (why would they?) and very few have auto loans.  As a result, Prime borrowers are penalized for lack of diversity in their credit portfolio - 10% of FICO.  

These negatives are beginning to stack up, but what's the overall affect?  Let's look at the numbers: below is a chart showing FICO score as a function of age (source: Credit Karma).

 

This figure should be very alarming to any unsecured lender heavily relying on FICO scores: the correlation between FICO and age is extremely strong.  Prime borrowers, who would fall in the 25-34 bucket, have an average score of 649.  The average for a borrower of 55+ is 691.  This differential is completely unjustifiable and flies in the face of income data.  Below is a chart of the average household income by age.  We note that the average for the 25-34 group is $51,000 while the average for the 55-64 group is $56,000.  That is a small income differential for a very large FICO differential. Additionally, we draw attention to the fact that the "spread" between age groups has tightened considerably since the Financial Crisis - a trend that has not been extrapolated to the FICO distribution.  All of this should give us serious doubts about the viability of FICO in determining a recent graduate's credit risk, yet student lenders continue to limit a borrower's access to credit unless they have a FICO of at least 700. 

Byline:
Derek Kaknes