Credit Score Victims

Section #1: Good Intentions

CREDIT SCORING is a terrible practice.

First, credit scores are not the objective beacons they pretend to be, and consumers pay mightily as a result. To help fully understand why, Lexington should bring in an applied social scientist. Oops, right here! I'll say more about the statistical fallacies surrounding credit scoring shortly.

Second, some lawyers contend that the practice of providing credit scores to potential creditors, insurers, and employers may well violate the Fair Credit Reporting Act (FCRA), an interesting civic issue with profound implications for the entire industry.

Third, certain government-overseen housing programs like FreddieMac rely upon the predominant credit scoring system whose underlying mathematics are still kept secret by a single for-profit corporate monopoly. Such secrecy (untested and unaccountable secrecy at that) is quite the conundrum in a country where citizens demand to know how tax dollars are spent.

Finally, and perhaps most outrageously, consumers are offered precious little information which might help them to optimize their credit scores. Sure, there are plenty of web sites which detail the basic outlines of what comprises a score, and we'll review all of that here too. Unfortunately, though, such dazzlingly hypnotic and overly general information doesn't really help real-life consumers with street questions like, "What will help my credit score most today: Paying off a charged-off account from five years ago, or closing two or three of my fifteen credit card accounts? Paying off a student loan, or paying off a credit card? Paying down one account entirely, or paying down all my accounts a little bit?" (Toward that end, Lexington's Concord Premier level of service constitutes a rare lighthouse of individualized guidance.)

So as a result of the rampant unfairness, institutional secrecy, rotten science, and a virtual dearth of truly helpful information, Americans are roundly and routinely victimized.

Good intentions. Nobody ever sat down and decided to make things worse for consumers. In fact, the intention was quite the opposite. Credit scoring was an attempt to remove issues like RACE, GENDER, SOCIO-ECONOMIC CLASS, and INCOME from an overall assessment of every consumer's credit report.

Back in the Good Old Days before 1970, a credit report would very often include such things as whether you were black or white, whether you embraced a particular religion or were atheist, rich or middle-class, whether somebody thought you were an alcoholic, courtroom quotes from ex-spouses, and whatever else they could find. Likewise, bankers once withheld credit to those whose appearance just didn't fit their idea of what defined a good human being. You could even be denied because the loan officer simply thought you looked strange. Sadly, sometimes the actual reasons were based upon racial preconceptions or similar prejudices.

Strange as all of that may sound today, the FCRA still draws a distinction between "investigative consumer reports" (like subjective statements by ex-spouses regarding moral character), an activity which was practically legislated away, and the kinds of consumer disclosures we now accept as the norm. The basic idea, then, for credit scores was a good one. It was an attempt to inject science into the process.

Section #2: What Happened?

So what happened? What happened was that a wacky group of Minnesota statisticians at Fair Isaac Corporation (FICO®) in the late 1950s decided to have a look at how historical variables (what a consumer did in the past) correlated with future behavior (what happened later). Not surprisingly, these brainiacs quickly found that the best way to predict whether a consumer is going to become seriously delinquent is to look at how he previously handled his accounts. So the "FICO® score" was born.

Now, all of that may sound fine, or even ingenious, but there are several serious problems afoot, and the first is scientific in nature. In statistics, results are measured by what us eggheads call the "R-value" -- whether a particular result just occurred because of dumb luck or whether it was real life stuff ("beyond chance" to use the parlance). The kicker is that you can get a VERY significant "R" when just a minority in your studied population tests positive. So, with credit scoring, if say 15% of people with scores in the 650-700 range are later found to be seriously late with their bills, then Fair Isaac will scream "Eureka!" and proclaim wild success with amazingly significant "R" but only at the expense of the other EIGHTY-FIVE PERCENT of the consumers in that group who would never even think of paying their bills late. Even worse, using this same example, if only a fifth of the delinquent 15% subset of this group actually defaults and never pays back the borrowed money (and the actual number is probably far less), then guess who in this 650-700 range gets blamed for that? Yep, the other 97%.

Next, consider what happens to the rest of the innocents in the 650-700 range. They simply bleed higher interest payments for mortgages and car loans and credit cards. They provide a terrific excuse for Citibank and Chase and Capital One to advertise wonderful interest rates but then actually offer much less favorable (and much more profitable) terms later on. Such consumers literally pay and pay and pay, all because of a cockamamie number that can predict statistically "significant" trends for large groups but so often tragically fails at the level of the individual person.

Another issue is strictly psychological. Numbers are seductive, and people love to be seduced. They want to know their height, their weight, their IQ, how high they can jump measured in centimeters, how many paint-balls can be hurled at an opponent, you-name-it. If a single number can provide the "right" answer, then we clamor for it. And of course, when it comes to considering applications for credit cards, just imagine how much easier it is now to simply use FICO® scores! Human beings are no longer required to read through credit reports to forge intelligent decisions. Instead, computers can electronically procure the FICO® scores and render instant judgments. Sadly, the problem of false positives (all those innocent folks in the 650-700 range mentioned above who are automatically judged by the worst behavior of their group's bad apples) is ignored.

Basically, with credit scoring, our society has traded the human problem of rampant subjectivity, where anything is ripe for discussion, for the mechanistic problem of impersonal automation, where nothing about a consumer's individual situation is considered. Clearly the first problem needed addressing, but couldn't smart people devise a better solution than this?

Section #3: Shoddy Math

Shoddy math. Making things even worse is just how FICO® scores are constructed. Here's practically everything Fair Isaac reveals about the scores, a bit of happy pap you've no doubt seen repeated on dozens of web sites: 35% of your score is influenced by account history (how timely you've paid), 30% to current account usage (how much of your credit is being used, with greater amounts being negative), 15% to length of credit history (the longer the better), 10% to new credit inquiries and accounts (with fewer being better), and 10% to the "credit mix" or variety of credit types present. Scores range from 350 to 850, with the mean value score being right at 725. In real life, favorable credit rates are typically extended to those with scores of 720 or above.

Now here's what they don't tell you:

Your credit score isn't just about you. If it was, providing it along with the rest of your credit report might not violate federal law, which stipulates that your consumer file must only (and obviously) be about you. Rather, it's about you and others. More specifically, Fair Isaac makes use of what they call "Score Cards," which groups consumers according to whatever criteria they choose. Then, they run what we statisticians call Pearson correlations between credit report items and subsequent late-pays for each consumer grouping. Through that continuous process, Fair Isaac stays on top of the variables du jour which may diagnose bad future news. The final step happens when your credit report is pulled and is analyzed through the use of those comparative algorithms, and a credit score is then reported which purports to predict the possibility that you are the type of person who may one day become seriously delinquent. Wowzah!

So does this sound kosher? Are prediction and speculation and comparisons with other consumers fair items to include in a credit report alongside the stuff that otherwise really is about a single consumer? Undoubtedly, the judiciary will eventually decide. Suffice to say, if I had a diagnostic FICO®-like score for corporate performance, I'd have to give Fair Isaac a 640, because I predict that the courts will one day kick their collective butts and force serious changes in the way consumers are manhandled.

Section #4: Secret Decoder Ring Needed

Secret decoder ring needed. Needless to say, the underlying arithmetic upon which FICO® scores are based is kept top secret by the Fair Isaac Corporation. Put simply, if they gave away their for-profit secret sauce, somebody's business plan would likely be threatened.

Moreover, there are problems with the secrecy.

First, with so much at stake (mortgages, insurance policies, certain employment categories, car loans, and more), consumers rightfully want to know specifics regarding how to improve their scores. Fair Isaac's pat answers, stuff like "just pay everything on time, and pay down your debt," just doesn't satisfy. In fact, disappointingly, sometimes paying down debt simply has no scoring impact at all. For example, paying off an installment loan almost never helps a score, while paying down revolving credit card debt almost always will. Similarly, paying off a debt that was previously charged-off will also likely have no positive impact. (That said, doing the right thing merits other worthwhile life rewards.) For these reasons, Fair Isaac's summary statements which masquerade as score-enhancing advice often accomplish nothing.

Second, with certain government jobs and federally overseen home mortgages riding on the proprietary for-profit FICO® product, one would think that Congress would demand more transparency regarding a credit score's actual construction. And, of course, when citizens make enough noise about the matter, that will surely come to pass. Government dependence upon Fair Isaac provides another compelling reason for eventual systemic change.

Section #5: Improve Your Score

Improve your score. Toward this end, you need to know where you stand. The Fair Isaac Corporation now sells the scores, one for each of the three major bureaus (and you need to buy all three, an unfortunate circumstance that keeps that company happy), at their otherwise excellent consumer web site, MyFico.com.

Once purchased, you'll have your credit reports as well as your FICO® scores in hand. At that point, consider hiring an inexpensive credit score coaching service like PerfectYourScore.com. Otherwise, very generally, here are the steps you need to take to elevate your scores:

1) Eliminate any negative items. Whichever way you choose to handle the matter, whether you elect to take matters into your own hands or hire an attorney (anyone care to guess why I heartily recommend Lexington Law in this context?), the deed must be done. Negative items are score killers.

2) Pay down any credit card with a balance of more than 50% of its overall line of credit. If you have no cards at 50% utilization, then pay down any outstanding revolving credit balances at all.

3) If you have a limited payoff budget, don't bother allocating resources to any accounts which have charged-off at this point, unless you can negotiate what credit pros call "payment for deletion," where the creditor agrees to mark your credit report positive after receiving the money. It isn't the outstanding balance on a charged-off account that lowers your credit score. Rather, it's simply the fact that the account EVER charged-off which depresses your score. Keep in mind, though, that some action on your part must eventually be taken with these accounts, whether you eventually pay them or challenge them in some way, in order to prevent further collection activity or possible legal consequences.

4) No matter what some well-meaning friend or relative advises, don't start closing accounts willy-nilly. If you need expert consultation on this or any other point, go get it.

Throughout the 1960s, 1970s, 1980s, and 1990s, consumers couldn't even buy their credit scores. By 2001 the State of California had fixed all of that for everybody, ruling that California residents were entitled to know everything the credit bureaus were reporting about them. Very quickly, Fair Isaac and the big three credit bureaus realized that it wouldn't make sense to allow only people who lived in California to view their scores, so they reluctantly opened it up to all of us.

Ironically, Fair Isaac and the bureaus now celebrate their newfound openness, because selling the scores is apparently quite a sizeable revenue source. The last laugh, however, may well belong to the consumer as professional scrutiny like that found in this article begins to undo the monopolistic, secretive, and ultimately consumer-unfriendly practices engaged by the prevailing credit score purveyor.

SUMMARY: Credit scores...

• provide speculative "best guesses" rather than factual descriptions about consumers.
• may violate federal law when included with a credit report.
• introduce an element of secrecy into government-overseen mortgage programs.
• are difficult to understand since their underlying mathematics are constructed for-profit.

·

Randy Padawer (PsychDoc) is a Ph.D. in clinical psychology whose research interests range from personality testing to consumer credit. He has been featured in publications as diverse as the Journal of Personality Assessment, the Journal of Consulting and Clinical Psychology, and Smart Money Magazine. Dr. Padawer co-wrote the best-selling "FICO® 850" seminar for The Motley Fool, and he has consulted for Lexington Law and others regarding consumer behavior and credit reporting.