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Credit Karma’s Ken Lin on FICO’s New Scoring Model

In the age of the credit crunch, credit scores are the passport to your financial future.  The new year has brought many things, and with it, a new scoring model.  We spoke to Ken Lin, CEO of Credit Karma (a website that lets you check your credit score for free — anytime, anywhere) about the change in the FICO credit scoring model to get a better idea of what the changes are and how they will affect you.

Can you give us an overview of the new scoring formula?
It hasn’t been fully disclosed or anything.  They’ve selectively agreed to point out certain things.  But the way it looks like things are going to work, it’s going to be a more holistic view on a person’s credit.  So what that means, is that it takes fewer of the micro late payments and looks at your credit on a more holistic level –  late payments or single late payments don’t matter as much on your credit score, but long term late payments will have a bigger impact.  I think that’s one of the first changes.

I think a secondary change is really around the authorized users and the notion of piggybacking your credit.  I think that’s been one of those things where people have gamed the system — where if you add an authorized user in your credit report, you are in fact transferring some of your good credit over to that person — and basically stop that process or that loophole, if you will.  And really the third component or maybe the global picture, they’re really trying to help lenders better determine who are lower risk people.  I think that’s the ultimate objective.  But at the high level, it’s all about making more of a holistic view on the credit score, rather than the minutia, as well as fixing a few of the loopholes in the hopes of getting a better [read] for lenders.

So, when does this new scoring method go into effect?
Well, it’s interesting.  So what happens most of the times with these scores, lenders will actually test it.  So it launched I think actually today or yesterday, with TransUnion.  I think Equifax is coming down the road, and Experian hasn’t actually released the date.  But normally  what happens with new credit scores is that financial institutions have billions of dollars in their portfolio based on existing credit scores, so they’re generally hesitant to switch over completely or unilaterally to new credit scoring systems without testing it.  What I suspect, is that banks will slowly migrate as they test it.  And what they’ll ultimately do is test this score against the old score and see if there are actually pickups in the performance of being able to detect chargeoffs or risk.  I think once those numbers come in, they’ll be more likely to make a final switch.

What spurred this change, or does FICO regularly and routinely change their methodology?
You know, credit scores haven’t stayed the same, really ever.  I think historically there have always been updates.  There have always been tweaks to get them to normalize for different years or economic conditions.  But even if you look at the current FICO score, its been updated five or six times since its original release in the late 90’s.  So this is a constant, but I think this one is a little bit more radical from the standpoint that they’re trying to address more of the macro level issues instead of the loopholes that we spoke about.  But you have to keep in mind that credit scores are constantly evolving, and its never the case where you have one consistent score from the beginning of time for you.

OK.  I was wondering if it had anything to do with banks lending money to unattractive borrowers and the whole sub prime debacle that we just went through?
You know, I think that probably is a little bit of the underlying effect.  I mean, credit scores, they’ve performed well.  I think the whole sub prime debacle is more of the factor that the banks got a little more greedy.  They were continually lowering their criteria or their threshold in the hopes of making more profits, and it just ultimately backfired.  I think part of this is grounded in the fact that you always want to be able to better mitigate your loss or predict losses based on your credit score.  I don’t think credit scores ultimately brought down the industry.  It was more of a case that the industry was a little too greedy and willing to lower their standards.

Do you think this new method will prove to be more beneficial to people, or do you think that a lot of people will see their scores being lowered?
Its too early to tell, but this score is meant to benefit banks and lenders — quite honestly, right?  Credit scores are always built for lenders.  Consumers are finally becoming aware of it because they know how much impact it has on their financial well being.  But historically these things are built for lenders.  And the ultimate gauge of whether this score is successful, is if it will be able to differentiate good borrowers from bad borrowers.  And that will be the decision.  So from a consumer’s standpoint, it’s important for them to always be aware of what their credit scores are, and making sure their credit reports are accurate.  But I think this particular change will have little impact on the consumer — more of the impact is really going to be focused on the lender and their profitability.

Like you said earlier, it’s going to be focused more on the minutia.  I heard that the smaller problems, like if you have a doctor’s bill for $100 that accidentally went into collections, it would mean less.  Is that true?
Correct.  Right.  It de-emphasizes the smaller aspects and looks more at the macro level trends.  So if you have a long history of always being late or being delinquent on your bills, that’s taken into more of significance, rather than if you have a small doctor’s bill, a collections notice, for a $100 or less — it has less of an impact.  And along the same lines, if you recently missed a payment, but you’ve always paid your bills on time, that will also have a much lower impact on your credit score.

I was also reading that they’re going to be focusing more on the credit to debt ratio.  Does it hurt your score to have a credit card open, but to never use it, if it’s paid off?
So, they’re starting to look a little bit more closely on inactive accounts.  I think the general rule of thumb is if you have a line of credit that’s available to you that you don’t use often, use it every couple of months to show that there is activity so that it continues to contribute to your active credit line.  I think the new model suggests that they are going to be de-emphasizing credit limits if you don’t use them.  So a simple way around that is to buy a tank of gas every other month with your card so that you continue to show usage.  That will kind of mitigate any of the negative impact of having credit lines that sit dormant.

Will the new scoring model change the way they differentiate between labeling scores good, fair, poor and excellent.
I don’t think so.  Historically, credit scores have been normalized.  Meaning that at any given year, they expect the same score to have the same amount of chargeoff.  So I think because everyone is so used to that standard, they’re not going to be changing the definition of good, bad, and poor.

What about precautions?  Are there any new ones that we should follow or should we stick with the same rules that we’ve been doing, like keeping a healthy credit to debt ratio and keeping accounts that are paid off open?
Yeah.  There are so many components that go into a credit score — I think at the last count it was over 200.  And for a consumer to actively monitor 200 or try to you know, eek that last 2 or 3 points of improvement really becomes difficult.  So following the general rule of thumb of not carrying too much debt, making sure your credit reports are accurate, not having too high of a utilization — those general types of tips will be always true.  I think consumers should be more worried about those macro trends, instead of doing X,Y, and Z to get the last three points of improvement.

And is there any advice to someone who’s planning to purchase a house or car this spring, and will need to have a good score?
Yeah.  Well, I think credit scores are more important than they’ve ever been in the last ten years, if you will.  If you’re looking to make a major purchase, I think consumers need to start being aware of their credit scores today.  And anything lower than a 720 for example, on a mortgage is going to be really difficult to get good financing or at least financing at the best rate.  So consumers need to be diligent about monitoring their credit scores probably 6 months to a year ahead of that purchase.  Ideally they’re constantly monitoring their credit score.  They need to be very cognizant of cleaning up their [credit] lines, making sure they’re paying down their debt, and getting to the threshold of 720 plus, so they can get the best rates.

Will consumers be able to get a free copy of their credit score once the majority of the banks transition over to the new scoring model?
Well, this is a really interesting point.  I mean, historically you can only get your FICO score from myFICO.  Experian recently cut off their relationship with them.  So you can only get two of your FICO scores through myFICO.  But even FICO released the fact that they’re actually not planning to release this new FICO score to consumers for another two to three years, so these recent changes kind of, again, support the fact that from a consumer’s perspective, they can’t get too caught up in what they need because they still won’t technically have access to it for a few more years.

Is there anything else you’d like to throw out to our readers?
You know, I think the continuing message that we continue to support is that credit scores are very important for almost every aspect of financial health.  This is a minor change that consumers should be aware of, but they should definitely be aware of those macro level changes in terms of the economy and having good credit.  That’s just one thing that we continue to tell consumers — be diligent about knowing your credit score and really how they work.

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