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Credit Report: The Calculation For Credit Score Needs To Be Improved
Lenders Can Be In The Dark On True Credit Risk of Borrowers
Because the stock market has been too volatile for me to stomach and banks are giving us about 1% interest on savings, I decided to try investing in peer to peer lending, such as what Lending Club supports.
Knowing what my credit scores have been over the years and what my actual record was, I extrapolated the data and felt that I could loan funds to folks with a 650 or better score. There were other attributes that I paid attention to. But this one was one of the most important.
What I didn't realize at the time was that credit score values can be VERY misleading and actually prevent you from knowing the truth about someone's credit history.
Take me, I've been getting penalized for two late payments that happened a couple years ago. One was related to an online processing error. The other was related to a payment oversight (I was traveling). In one case, we are talking about $30. In the other case, we are talking about $200. Yet in each of these situations, the payments were cleared up and paid in full within 30 days of my being notified. Yet, my credit score moved from good to fair, with each of the three credit agencies.
Over the course of my adult life (3 decades so far), I've owned (had mortgages for) 3 homes that were worth hundreds of thousands of dollars. Never had a payment been missed or late. I've had taken cash advances from credit cards for 10s of thousands of dollars. Once again never had a payment been missed or late. I have made a lot of money for a number of lenders and have been extremely reliable and consistent about paying my debts, yet for the last few years, I have been labeled "fair" in terms of credit risk, with my scores hovering around 711 - 715.
A credit report provides a FICO score, which is a measure of credit risk. FICO is actually a software company out of Calfornia and was founded in 1956 by an engineer, Bill Fair and mathematician, Earl Isaac. Payment History is currently 35% of this score. The other 4 components are: Amount Owed is 30%, New Credit 10%, Length of Credit History 15% and Credit Mix 10%.
Back to the Lending Club investment experiment. About 18 months ago, I decided to see what I could do with about $8,000. I assumed working with folks that had a credit score of 650 or higher would be OK. I selected them based on other things too like the direction their credit score was going (holding its own or going up vs going down) and good payment record (always on time) as well as interest rate they had been paying.
I financed 113 notes. And, right now, 47 are fully paid (some paid up early). And, 47 are current. Unfortunately, 11 loans have defaulted and have therefore been charged off. Plus 7 are late (they are now all over 60 days late... this threshold seems to always be hit by those headed for defaulting). And, one is in the 30 day grace period. This totals 19 of the loans or 17%!
Talk about being blind sided! Each of these loans had $85.98 to $257.30 remaining on the principle. So, in terms of dollars, $1,819.41 had to be charged off, $1006.41 is late and $114.85 is in the 30 day grace period. When you add these numbers up it's $2,940.67 that I, at this writing, have likely lost. That is 37% of my original investment of $8,000! Granted, this is offset by interest I am making on the people who are making their monthly payments. But, based on what has happened to date with the defaults, I am quickly approaching a 1% interest rate and possibly even a loss before all is said and done.
Pretty shocking, I know. Something good can come out of something unfortunate a lot of the time. And, I think what is good for me here is understanding just how much lenders can be in the dark on the folks that want to borrow from them. One major factor in this appears to be how credit score is arrived at.
I took a closer look at the people that defaulted on the loans I gave them. And, although a lot more analysis needs to happen (by FICO with a good cross section of their user community) I feel that if just a few changes could be made to the credit score algorithm, it could be a lot more accurate and therefore valuable to potential lenders.
Essentially, these few changes relate to the Payment History portion of the score, with certain aspects weighing more heavily and accurately:
(1) Defaults/late Payments (2) Amounts of Money Involved (3) The Severity of The Reason (fraud, admin error, etc).
(Note: the Payment History portion of the score would be altered to reflect these conditions for more appropriate periods of time too.)
Additionally, (2) Amounts of Money Involved should be weighted in the algorithm via the use of tiers. Perhaps something like:
< or equal $10
< or equal to $100 > $10
< or equal to $500 > $100
< or equal to $1000 > $500
< or equal to $5000 > $1000
< or equal to $10,000 > $5,000
< or equal to $100,000 > $10,000
< or equal to $500,000 > $100,000
< or equal to $1,000,000 > $500,000
Any credit score formula improvements should inherently close down easy ways to manipulate scores. Currently, there is even a Hubpages article called: "Your Credit Score: 550 to 750 in 12 Months". This further demonstrates the fact that the credit score calculation needs to be improved to prevent this kind of thing from happening.
FICO, I'm sure, is evolving the way the score is calculated. The key here is to both identify and prioritize the scenarios that need to be supported/shutdown, and determine/act on the algorithm changes that will give them the most bang for their buck now.