23 January 2008

Chasing A Higher FICO Score

The past weekend, I read a story in the Denver Post about the latest credit scoring formula. Monday night, as is often the case, I had a bout of insomnia, and attended to a number of financial chores that I handle irregularly.

I prepared a family balance sheet based upon the end of year statements from banks, retirement accounts, the mortgage company, and so on, that we had recently received. Then, still not sleepy, I decided to use the Denver Post link to obtain free annual credit reports from the three major credit reporting agencies, a step provides a warning sign to pick up identity theft and an opportunity to catch any mistakes in our credit report.

All three reports contained mistakes. I'm unlikely to correct any of them, however, because none of the mistakes appeared material. They weren't the kinds of mistakes that looked likely to hurt my credit rating.

I also paid to get my credit score from each company. Two of the companies charged me $8 each for the information, while one charged me $6. The total expenditure was $22, something I normally hate doing, but figured was worthwhile given that interest rates have gone mad and might create a refinancing opportunity for my mortgage at some point.

Assigning credit scores is not a science. Equifax uses a scale that goes up to 850 (apparently it hasn't implemented the latest Fair Issacs scoring model yet). TransUnion and Experian used a scale that goes up to 990. None of the agencies gave me the same score, although the TransUnion and Experian scores were quite close. Scores in turn are used to sort you into several general categories (not necessarily equal in number of members). The top three are various grades of "prime" credit (one agency uses words, while the other two use letter grades). The lower categories are gradations of bad credit to which the infamous "subprime" label attaches. It does turn out that all three agencies put me in the same general grade of credit.

Particularly interesting, however, were the explanations for the scores as I didn't receive a "perfect" score (almost no one does). Both of the companies using the newer FICO scoring system had the same four reasons.

Two of the reasons flow my mortgage. FICO's system thinks that it is too small and that too little has been paid down on it. FICO's system is wrong, mostly because it lacks or isn't using, other key pieces of information, which are the value of our home, the amount borrowed initially when we bought our home, and our income. We have refinanced our home about three times since we bought it as interest rates fell (and have been better off in the end for having done so each time dropping the percentage rate several percentage points and getting a fixed rate for the lowest rate with only modest transaction costs each time). Each time, we only refinanced the current balance due and paid for the fees out of pocket, rather than pulling money out of the house. We also didn't buy the most expensive house we could afford, instead opting for a larger down payment.

The FICO system appears to be implicitly assuming that people normally buy the most expensive house that they can afford with very little money down, and that the starting balance of the current mortgage reflects the money initially loaned to buy the house. The FICO system appears to disregard equity accumulated and lending approved for higher principal balances in the past, under previous iterations of someone's mortgage. But, if you refinance you home a number of years into the loan, experience appreciation in your home value over the period after you buy your home, make significant renovations which are financed with debt, or have a larger than minimum down payment, the system appears to assume that you have less equity than you do and hence underestimates your creditworthiness.

Needless to say, I don't plan on borrowing money I don't need, secured by my home to make myself more creditworthy. So this is a flaw that will have to be fixed with others parts of a credit application should I need credit in the future.

The other reason, expressed in a couple of different ways that amount to the same thing, apparently given high importance under the new scheme, is that my monthly credit card balances on the card I use, are fairly close to my total available credit with those creditors. According to the Denver Post, the best approach under the new system is as follows:

• Don't use all your available credit. A good ratio is 25 percent of what you have.
• Don't close accounts you're not using unless you really don't need them. It raises your use-to-limit ratio.

I'm mostly a convenience credit card user. I hate carrying a bulky checkbook in my pocket, I like being able to monitor my spending each month with an itemized statement of my purchases, and we get rewards for spending on the credit card. I avoid using more credit cards than I have to, mostly using just one, so that I don't get the statements confused and have a consolidated record of my spending. But, our spending is fairly stable from month to month, so we've never bothered to ask to have our fairly low credit limit increased because we rarely run up against it.

It turns out, however, that this is quite bad for your FICO score. So today, I made the simple call to the credit card company saying, "hello, I'm a good customer who pays your bill on time, could you please increase my credit limit." Minutes later, they did, and I suspect that my FICO scores have surged as a result.

Credit limits relative to outstanding credit are a bad basis for FICO scores. It is easily manipulated, in just the manner that I just did. It is also injects inherently circular reasoning into the system. Someone who is relying almost exclusively on your FICO score to determine whether or not to grant you credit is using an instrument based in part on their own credit decision. Finally, it is worrisome in that the system injects the prejudices of bank officers involved in setting credit limits for customers, rather than mere payment experience, into decision making tools that are often used in areas far afield from actual credit transactions. For example, FICO scores are used to underwrite insurance policies, a controversial practice with merits on both sides of the argument that the Colorado General Assembly is considering a bill to ban this year.


Jon W. said...

I had always thought that, although it's good to have available credit, it's not good to have too much, so your observation about use-to-limit ratio is surprising.

I have two credit cards that I regularly use. I also have a card I never use, but that I haven't closed, in part because it has the oldest "member since" date on it. You're saying that I may as well hang onto it?

With home prices stagnating and the stock market practically in free fall, I'm actually worried about the economy, which is kind of a first for me.

Andrew Oh-Willeke said...

Not only should you hold onto your extra credit card, you should use it every two or three months, so that it continues to be classified as an active line of credit that is largely unused. I agree this is counter-intuitive, although there may be some wisdom to it (available unused credit is a nice thing to have if you hit a bump in the road and people rarely increase your credit limits when you are in financial trouble).

Some worry about the economy is justified. I think we're in for a recession, although I don't think it will be terribly long or terribly deep.

David Migoya -- Denver Post said...

Thanks for Reading!
One thing of clarity: the Big 3 reporting agencies will provide you their proprietary credit scores from their own formulae, not the FICO score unless you specifically request it.

You might have better luck at www.MyFICO.com for a copy of your FICO score.

Good going on the annual credit report! Everyone should!

Brian Lewis said...

I will start it with an example as in you may be out of school, but that doesn’t mean you’re free from report cards. In fact, if you want to buy a house, or any other big-ticket item, a lender will look up your “grade” as soon as you come knocking. That grade is your credit score.
There are many varieties of credit scores available to lenders. But the most widely used for large loans are Credit Scores, which are based on a scoring system developed by Fair, Isaac & Co. Following are five things you can do to boost your creditworthiness, plus more information on obtaining your personal score.
1.) Review your reports from all three credit bureaus for accuracy once a year as well as several months before applying for a loan.
2.) Paying your bills on time is always a good practice, and it’s especially critical that you make prompt payments close to the time you need a loan.
3.) A heavily weighted factor in your FICO score is how much money you owe on your credit cards relative to your total credit limit. Generally, it’s good to keep your balances at or below 25 percent of your credit card limit
4.) Pay off debt rather than moving it around i.e. since the ratio of your credit card balance to your credit limit is key, closing out an account and transferring the balance simply means you increase that ratio, which is likely to lower your score.
5.) Don’t close unused credit card accounts near loan time.