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The Beginning of the End for FICO Scores?

by John Birge, Chief Credit Officer

FICO scores have become a hot topic in marketplace lending. Over the past few months, a number of such lenders have criticized FICO and announced that they will no longer use the score for underwriting, favoring instead new data inputs to determine a borrower's creditworthiness.  This trend was summarized in a recent Wall Street Journal article titled “Silicon Valley: We Don't Trust FICO Scores."

 Eschewing a score that has been ubiquitous since the 1980s and is used by banks fits squarely within the broader theme of the disruption of traditional underwriting.  So is this the beginning of the end of the FICO score or is this largely hype, what I refer to as the “marketing of underwriting?”

To answer this question, it’s important to understand what FICO is and perhaps more critically, what it is not.

 

What FICO Is

FICO is a statistical model that uses consumer credit bureau data to predict how likely one is to pay their obligations in the near future. The data variables come from one of the “big three” consumer credit bureaus - Equifax, Experian or TransUnion. So in practice, individuals actually have three unique FICO scores, though they are normally fairly close to one another.

 Per FICO, there are five key types of variables that drive the score:

  • Payment history
  • Amounts owed
  • Length of credit history
  • Credit mix
  • New credit

One of the main criticisms of FICO is that it only considers historical credit events.  This, of course, is true!  And the inputs do tend to focus on negative items such as delinquencies, judgments and liens. This combination of looking backward and focusing on adverse actions, while far from perfect, has proven to be remarkably predictive, performing well across a variety of lending products and various economic cycles.

 

What FICO Is Not

Since FICO sources its input variables from the consumer credit bureaus, it has no “direct knowledge” of any of the following data points which the bureaus do not track:

  • Income
  • Debt-to-income ratio ("DTI") or cash flow
  • Employment history
  • Education history
  • Assets including retirement accounts
  • Checking or debit card behavior 

It is very common for lenders to use income and some form of DTI in conjunction with FICO to make underwriting decisions.

 What about employment and education history?  While most underwriters believe this information contains incremental predictive value, utilizing this data for credit decisioning could present serious consumer regulatory concerns, specifically with respect to the Equal Credit Opportunity Act (ECOA) and the Fair Credit Reporting Act (FCRA).

 It should also be noted that FICO does not include other variables that have become fashionable lately:

  • Social behavior (e.g., Facebook data, LinkedIn connections)
  • Session statistics (e.g., dragging a slider to the max loan amount)
  • Text mining variables (e.g., whether a person has a gmail or yahoo email domain)

These types of variables are certainly intriguing from a “big data” and behavioral science perspective and have become part of what I refer to as the “marketing of underwriting.” But utilizing this data could present potential regulatory issues. And of course there is the question of whether the data actually adds value, which is discussed in this Wall Street Journal article - “Facebook Isn’t So Good At Judging Your Credit After All.”

 One argument for delving into nontraditional data is that 40 million Americans don’t have a FICO score due to no or “thin” credit history.  And perhaps not surprisingly Millennials represent a disproportionate percentage of this group. For this population new and promising data sources include positive rental payments and positive payment of utility bills. These variables are generally regarded as compliant from a regulatory point of view. I would not be surprised if future versions of FICO incorporate this data.

 

Why Some Marketplace Lenders Believe They Don’t Need FICO to Underwrite

 Depending on the product, marketplace lenders may target segments that are known to have high FICO scores. For example, some marketplace lenders loan only to people who have graduated from elite educational institutions with degrees that afford high earning potential. In a sense, these lenders rely on the admissions departments at the nation’s best colleges and universities to do their underwriting for them. An underwriter would simply need to check a few additional data points related to derogatory payments and DTI ratios to finalize an underwriting decision. In statistical parlance, this population is so super-prime and homogenous that FICO doesn’t provide any “orthogonal” or incremental predictive value.

 It should be noted that companies that no longer use FICO for underwriting typically do still rely on the score for loan sales and securitization, so FICO is in fact still an important variable for these lenders.

 

Conclusion

FICO is not perfect but it is has demonstrated consistent performance across a variety of products and economic cycles i.e., it is statistically robust – a very desirable attribute. Used in conjunction with business judgment about current and future economic conditions, the score is very effective.  In addition, FICO is constantly being improved. For example, a next version of the score could include positive remittances for rental payments and utility payments. While marketplace lenders – and traditional lenders too – will continue to identify and leverage new, compliant data sources to enhance their underwriting models, I expect most lenders will continue to rely on FICO as a significant component of their underwriting policy. 

Instead of borrowing, should my business sell equity?

by Mark Rambler, President, COO and Co-Founder

One of our small business borrowers is an up-and-coming, tech-savvy platform that connects creative content providers to established brands. In my initial conversation regarding funding options with the owner (we’ll call him Tom), we discussed the relative merits and limitations of borrowing funds vs. selling equity to raise the capital he needed to grow. In the end, Tom ended up taking out a loan with our company, Credibility Capital, but for other small businesses selling equity may be a solid option depending on a variety of factors. 

The first consideration for business owners is whether or not they can attract equity investors to raise the capital they need. While most larger companies have sold shares at some point in their lifecycles, it can be considerably more challenging to convince someone to buy equity in a small business.  An equity investor will want to know when she will get her money back and at what return, two factors that are dictated by a realization event such as dividends, recapitalizations, a sale of the business or even an initial public offering. These events are notoriously difficult to predict and tend to be rare, but are most likely to occur for businesses that that are on a clear growth path or that generate sufficient cash flow to support scheduled distributions to equity owners. 

For businesses that can effectively attract equity investors, selling equity to fund growth is a good option. While some debt is no doubt a great way to leverage assets to access additional capital, too much debt can lead to burdensome debt obligations that can be a major drain on a business. In some cases, if a company can’t make payments on its debt obligations, the lenders may foreclose on the business.  Equity funding frees companies from those repayment obligations.

Another advantage of selling equity is an increase in the number of stakeholders who are incentivized to make the business successful.  Each equity owner brings unique experience, diverse skills and a vast network to the table, all of which can add tangible value to the company’s day-to-day operations and future growth potential. 

On the flip side, selling equity by definition dilutes the owner’s interest in the company. This dilution could translate into three adverse impacts: 1) the owner stands to gain less value upon a realization event and/or through annual distributions; 2) the owner’s control over business decisions diminishes; and/or 3) the owner may be required to share more detailed information with new equity investors, inviting scrutiny that could slow progress.

From a practical perspective, equity transactions are complex in nature, requiring time and money to structure.  Small businesses must first be valued, a difficult exercise that requires extensive research to understand valuation metrics for comparable companies. These valuation metrics are generally not disclosed to the public but business brokers (or investment bankers for larger companies), accountants, or legal counsel can provide insight.  Once a valuation is set, the business owner and the equity purchaser must agree on a broad set of terms related to access to financials and other records, input into day-to-day operating decisions, and control over broader strategic company matters. 

If after thinking through these considerations a business owner decides to sell equity in her small business, I recommend that she speak to many potential investors because the market for small businesses is illiquid – a broad range of prices and terms may be available. Nolo is a good resource for free information on legal matters and this article in particular is a helpful place to start - Raising Money Through Equity Investments.

If the business owner decides instead that a loan is the right path, I recommend reviewing the Small Business Borrowers’ Bill of Rights to make sure the owner borrows responsibly.

To borrow or not to borrow?

by Mark Rambler, President, COO and Co-Founder

As the chief operating officer of Credibility Capital, a small business lender, I am often asked, “How can my business get a loan?”  While that question is an important one, I want to tackle a different one here: “Should my business get a loan?”

The first step to determining whether your small business should borrow money is to get your company’s finances in order so you have a clear picture of capital inflows and outflows.  This will tell you how much debt you are able to service month to month. To do this, you’ll want to invest in quality accounting software.  Accounting software provides a snapshot of the health of the business and offers a variety of features from basic accounting tasks to tax preparation – all of which help business owners save time and better manage finances. Business owners can choose from a wide selection of products including QuickBooks, Xero, FreshBooks, Wave Accounting and Zoho Books.  You’ll want to research each to understand costs, ease of use, small business product features, and customer support to understand if it’s right for your business. Business News Daily published a helpful 2016 Guide to the Best Accounting Software for Small Business.

Now that your business finances are organized, the next step is to develop an actionable business plan to determine borrowing needs. For those not comfortable with business planning and financial forecasting, I recommend considering a business planning program such as LivePlan, Biz Plan Builder or Business Plan Pro.  Through question wizards and simple templates, these programs walk a business owner through relevant costs and revenue assumptions to estimate how the business will perform over time.  This will help you determine how much debt funding the company will need over time and, more importantly, how much debt the company should prudently take on.

The final step is to determine why you might want a loan. Based on your financial situation and your business model, loans could help address a variety of needs.  For cash-flow negative businesses, a loan could help fund operations needed to move the business from red to black. For cash flow positive businesses, commercial loans can be used to fuel business expansion across many activities. Credibility Capital borrowers have used loan proceeds to hire additional salespeople for an athletic apparel boutique, to market aggressively to grow their insurance client base, to purchase materials to increase kayak production, to install an outdoor patio at a live music bar, and to bridge a period that would otherwise put the company in deficit territory due to building up a new fleet of cars for a transportation provider.

 If you find that you are in a position to use a loan for any of the above purposes and you have confirmed that you can pay off a loan based on your current financials and future projections, then you can answer YES.  If you do end up borrowing, carefully consider the rate and terms of the loan.  Thanks to your accounting software and business plan, you’ll know exactly how much you can afford to borrow and you’ll have documentation ready to shop around for the best possible deal.