Building Assets, Building Credit: Creating Wealth in Low-Income Communities

Chapter 8. Credit Scoring's Role in Increasing Homeownership for Underserved Populations

Credit scoring grew out of the need to offer more credit more quickly, and without discrimination, to an increasingly mobile population after World War II. It made lending processes faster, fairer, and more accurate and consistent . Loan decisions could be made in minutes, rather than days or weeks. The extension of credit could be based only on factors proven (not assumed) to relate to future repayment. Sophisticated scorecard models precisely weighted and balanced all risk factors, so decisionmakers could apply one consistent measure of risk to all applications. This made credit more accessible and affordable to millions of Americans. Credit scoring such as FICO® scores are accepted, reliable, and trusted to the point that even regulators use them to help ensure the safety and soundness of the financial system.1 History, Concepts, and Benefits Bill Fair and Earl Isaac developed the first commercial scorecard systems in 1958 for St. Louis-based finance company American Investment. Their initial projects successfully demonstrated credit scoring’s financial value. Scoring systems reduced delinquencies up to 20–30 percent while maintaining similar volumes of 173 Credit Scoring’s Role in Increasing Homeownership for Underserved Populations hollis fishelson-holstine 8 1. Testimony of Cheri St. John to the House Financial Services Subcommittee on the Renewal of FCRA Preemption, Washington. June 4, 2003. 12 7409-5 ch08.qxd 7/7/2005 10:13 PM Page 173 loans, and could also be used to increase lending volume by 20–30 percent at the same level of delinquency then when not using scores. Despite its obvious advantages , scoring was not widely embraced until the early 1970s, when bank credit cards were well established. Fair Isaac successfully developed the first bank scorecard system for Connecticut Bank and Trust. By the end of the 1970s, 60 percent of the nation’s largest banks, 70 percent of finance companies, most of the larger national credit card issuers, and all of the travel and entertainment cards employed quantitative credit-scoring systems on one or more types of credit.2 Credit Scoring Concepts The credit decision is a prospective one, that is, it emphasizes borrowers’ future behavior, not how they behaved in the past. Past behavior and current status are both useful indicators of a borrower’s behavior pattern, and therefore signal possible future fiscal conduct. The credit decision, then, relies on the premise that people will behave in the future, at least in the near term, very much as they have in the recent past. Credit decisions made without scoring rely on credit officers’ knowledge of the relationship between past behavior and future performance— and this knowledge, even at its best, is very imprecise. Lenders’ rule-based systems for approving or denying credit applications—known as judgmental systems —are often a series of hurdles or so-called knockout criteria. Every credit application must pass all the criteria in order to be approved. Because every factor is considered in isolation, there is no possibility for several strengths in an application to make up for one or more weaknesses. In addition, a person considering a loan application often ends up putting too much weight on different factors that represent essentially the same information. For example, younger borrowers are also less likely to have been at their job a long time or own their own home. By contrast, a scoring system, or scorecard, performs a very thorough analysis of available data and is based on a rigorous understanding of the relationship between past or present behavior and future performance. A scorecard analyzes all available relevant information to deliver a single score: a number that represents the risk (or odds of positive repayment) for a particular individual. Using scores, a lender can rank borrowers according to the likelihood that they will default on a loan or become seriously delinquent (late in payments). For example , in a system where higher scores mean greater likelihood of repayment, people scoring 200 would be less risky than those scoring 180, but more risky than those scoring 220 (see figure 8-1). Lenders typically establish a cutoff score representing the threshold of acceptable risk. So, a lender might set a cutoff score at a level where, for that lender’s portfolio, the odds of repayment are equal to or greater than twenty to one. The lender rejects those applicants scoring below the cutoff, while accepting those who score above it. Cutoffs can also be used to 174 keeping score 2. For a survey on the technical development of credit scoring, see Thomas...