Lenders are rethinking their reliance on credit scores. In the past year, an increasing number of banks have begun turning to court documents, phone bills and other nontraditional ways of measuring creditworthiness to bolster their lending decisions. The shift comes at a time when the financial industry is suffering from a record number of loan defaults, particularly in the mortgage business. Industry experts say the widely used credit scores, the most famous of which is called the FICO, have not proved as effective in ferreting out bad borrowers as many lenders had anticipated. (Read TIME's "Bailout Report Card.")
"The experience we have seen in the past year only reiterates that you need to do more than just look at a credit score when making a loan," says Larry Goldstone, chief executive of Thornburg Mortgage. "We have never had as much confidence in credit scores as the rest of the industry."
Companies that provide so-called alternative credit information say their business is booming, even as the rest of the lending industry continues to shrink. Banks once sought out such information as rent-payment histories to assess whether to lend to individuals who lack a credit score because they may never have had a credit card or mortgage and don't have enough credit history to generate a rating. These days, more and more banks are using the supplemental information, even with customers who have a credit score, in an effort to lower loan defaults.
"We have had very solid growth this year," says Thomas Brown, vice president of financial services at LexisNexis, who also helps run RiskView, a service that uses such public filings as court records and property deeds to assess credit risk. "Our data [are] being seen as useful by a wider variety of lenders."
Credit scores, first developed in the late 1950s, try to boil down to a single number whether a person is likely to pay back a loan. The most widely used ranking of individual creditworthiness is the FICO score. Fair Isaac Corp., which computes the number, won't say exactly what goes into the formula, but it is essentially a summation of an individual's credit history which loans were paid off and which weren't rolled up into a three-digit number between 300 and 850. The higher the number, the more likely you are to pay back a loan, the thinking goes. A few years ago, Fair Isaac calculated that the average FICO score in the U.S. was 723. Fair Isaac hasn't gone back to recalculate the average recently, but observers say it has most certainly dropped in the past year.
Fair Isaac and others helped fuel the boom in lending over the past few decades in this country by making it easier and cheaper to determine quickly who would pay back a loan and who wouldn't or at least so they thought.
A few years ago, Fair Isaac produced a chart predicting the odds that a borrower with a certain credit score would default on a mortgage. For example, it predicted that a loan to a borrower with a 680 score had a 1 in 144, or 0.7%, chance of becoming delinquent over the life of the loan; a person with a 700 FICO score would have a 1 in 288 chance, or just 0.3%.
Unfortunately, those predictions proved too optimistic. According to mortgage-data tracker First American LoanPerformance, banks have already foreclosed on or are in the process of foreclosing on 1.5% of the mortgages originated in the last three months of 2007 to individuals with credit scores between 660 and 720. And those mortgages have been around for only a year. Over 30 years, the delinquency rate on those home loans is likely to be much higher.
Consumer advocates have long complained that credit scores inaccurately measure borrowers' ability to pay back a loan and therefore make it more expensive or even impossible for people who have a low score, or none at all, to borrow. But the complaints about credit scores have fallen mostly on deaf ears in the lending industry. That seems to be changing.
Mike Mondelli, president of L2C, which uses historical phone payments and other records to assess an individual's creditworthiness, says his company's business accelerated in May and June of last year as it became obvious that more and more lenders were having loan problems. He says his company has signed on a number of new clients in the past year and that his clients are not using his company's data just to make new loans but also to better assess the risks of the loans they already have made. "Traditional credit scores do a reasonable job of separating the very bad from the very good," says Mondelli, "but when it comes to the average person, credit scores are not very effective at figuring out who will pay back a loan and who will struggle."
The bottom line for consumers: next time you rush to pay your mortgage on time, mail your phone-bill payment as well.