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5 Reasons New Lenders Are Ignoring FICO Credit Scores

Nick Clements

For years, FICO credit scores have played a disproportionate role in our lives. FICO, which is used by 90% of lenders in America, determines whether or not we can be approved for a mortgage, auto loan or credit card. It is also used to determine how much we can borrow, and what interest rate we will have to pay if we are approved.

FICO uses data from credit bureaus to assign borrowers a score between 300 and 850. The best scores are given to people who always pay on time, have limited credit card debt and no negative collections activity, judgments or previous bankruptcy filings. People lose the most points for missing payments, receiving collection items or filing bankruptcy.

During the 2008 financial crisis, the risk management tools used by lenders proved to be woefully inadequate. While our nations largest banks continue to rely upon legacy scoring methodologies, new lending startups have started experimenting with alternative methods for underwriting credit risk. None of these lenders have given up using FICO entirely, but they are looking for variables beyond FICO to make better lending decisions. Here are five reasons these new lenders are rapidly trying to find an alternative to FICO:

1. Millennials Are Not Using Credit Cards

This month, a survey revealed that more than a third of people under 30 years old do not have a credit card. In order to have a credit score, you need to have some form of credit. Historically, the credit card was the gateway product offered on the steps of the campus bookstore and used to build (or destroy) credit at an early age.

The CARD Act of 2009 limited the ability of credit card companies to market credit cards on college campuses, and this cut card issuance nearly in half. In addition, the Great Recession of 2008 has had a big psychological impact on millennials. Many people in this generation are shunning traditional credit products and are saving for the next crisis.

If you do not use credit, you will not have a credit score. However, millennials who decide to save money and avoid credit can actually be an excellent credit risk. A lender who quickly realized this is SoFi. Rather than relying exclusively upon your FICO, SoFi uses an underwriting model that also considers your university, course of study, post-graduation employment and income. SoFi's approach to underwriting may sound old-fashioned. I would argue that it is refreshingly old-fashioned.

2. Cash Flow Matters

In the years before the financial crisis, the entire lending industry became obsessed with credit scores. If your score is high, you could borrow an almost unlimited quantity. However, FICO is mostly a measurement of whether or not you are making payments on time. If you have an almost infinite access to credit, you can use credit to pay credit, as many people did.

Many lenders just ignored income, and used credit scores as a proxy for ability to repay. We let algorithms over-ride common sense.

New lenders are looking increasingly at cash flow in their underwriting. For example, Earnest does not have a minimum FICO. But they do look at your bank account and see how you manage your monthly cash flow. They want to know how much money you make each month and how you much you spend. If you can afford to add a loan payment to your monthly budget, they will proceed. But if you can't, they won't. Earnest will turn down an 800 FICO customer if they are over-leveraged or do not make enough money to support increased debt.

3. Medical Bills Are A Mess

Anyone who has had a medical procedure understands that the medical billing process can be complete chaos. There is often confusion regarding who owes what. And doctors regularly hand off invoices to collection agencies before the billing is settled with the insurance company. That is why 43 million Americans have overdue medical debt on their credit reports. CFPB Director Richard Cordray stated the obvious when he commented "it's hard for consumers to navigate the medical debt maze and come out with a clean credit report on the other side."

That is why FICO recently announced that their new score, FICO 9, will reduce the impact of medical debt on credit scores. However, new lenders have quickly realized that medical debt should be treated in a completely different way in their underwriting models.

4. Collection Items Are An Even Bigger Mess

Once debt is written off by a bank, it is often sold to a collection agency. That collection agency will regularly sell the debt to yet another collection agency. Often, the only proof of debt is a spreadsheet sitting in the office of a small, lightly regulated collection agency. Even worse, damage is done to your credit score when a collection agency registers an item on your credit report. However, the only way to fix that damage is time. After seven years, the item will fall off your report. And, as the collection item ages, its impact diminished over time. Whether you pay the item or not has no impact on your score.

That may sound shocking, but it is true. FICO admitted that only two things matter for your score: "has a collections appeared on your credit report, and when it was reported. So, whether or not you pay your collections off is really a personal decision."

FICO does not reward people who pay off collection items. As a result, collection agencies have started a side business. If you can agree a good deal with the collection agency, they will offer a "pay for delete" deal. That means the agency will remove the collection item from your credit report.

This system is a mess. And new lenders recognize the weaknesses in how collection items are captured, cataloged and stored. Even FICO recognizes the issues, and promises to improve the situation with FICO 9.

5. Other Signals Are Even More Important

If someone is looking to apply for a mortgage, their ability to save for a down payment and make rent payments on time would be a great indication of risk. However, FICO ignores this.

If someone is responsible, and closes credit cards that they no longer want, they can be punished by FICO.

If someone pays their utility bills on time, they are demonstrating personal responsibility. And that is ignored by FICO and the credit reports.

Helping these new start-ups are companies that are looking for new sources of data that can help provide a more complete picture of credit risk. Today, there are more than 400 companies capturing some form of data that can be used by lenders.

What Should I Do?

If you have an excellent credit score, you will likely have a lot of excellent options at both traditional banks and new lenders. If you feel like you fit into one of the five categories listed above, that does not mean that you have to be excluded from access to affordable credit. On my website, MagnifyMoney, I put together a list of many of these new lenders. These new lending models do not make it easier for people with a lot of missed payments and defaults to apply for new credit. If you have a bad FICO score because you have missed a lot of payments, even these new lenders will probably still reject you.

While these lenders are growing rapidly, we are still living in a FICO-dominated world and likely will for the foreseeable future. So, you should still pay attention to the metrics that are important to FICO. Open a credit card. Use less than 20% of the credit limit. And make payments on time every month. If you have a collection item, negotiate a settlement only if you get a "pay for delete." And hope that these new companies grow rapidly, so that FICO becomes increasingly irrelevant.

