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I’m still waiting for the day of that mega-class action lawsuit against Fair Isaac and the infamous “FICO Score” and I think we’re quickly approaching that day. The Sub-prime mess meltdown won’t leave anyone unscathed and FICO is near the vortex of the black hole.

I’m going to give you my theory on the top 10 flaws with FICO scoring in relation to what I’ve experienced and noticed over the past few years regarding FICO.

Problem #1. FICO score is fundamentally flawed in that it does not consider a person’s true ability to repay a loan. The biggest “missing” piece in the FICO score is a person’s net worth. You’ve heard or read the disclaimer on most financial investments such as mutual funds which reads, “Past performance is no indication of future performance” yet that is what banks are betting on with consumers. Supposedly, because you’ve paid loans in the past then it’s likely that you’ll pay loans in the future. This is a fundamental contradiction in investment theory.

Problem #2. FICO doesn’t factor in your “job marketability” in its score. There are simply some professions and businesses for which there will always be a need for and people who work in those fields are likely to almost always have a job such as plumbers or doctors versus jobs like real estate “flipper” or loan broker which come and go. Isn’t there a significant difference here between job/marketability and ability to repay loan?

Problem #3. As alluded to in problem #1, not having net worth factoring into FICO scoring means that a person who uses loans “creatively but securely” is penalized despite the fact of having sufficient funds to repay any loan. Case in point: Credit Card Arbitrage. I’ve borrowed upwards of 50k at 0% and re-invested those funds into high yield savings at 5%. There isn’t any risk to anybody here since the money is “in the bank” waiting to be repaid. Even assuming that the 50k was used for some other activity, if a person has say 150k cash in savings then there is little risk to the bank but this is no where to be found in FICO yet I’ve seen my FICO swing from 725 to 757 for doing nothing but borrow low and invest high.

Problem #4. Closing unused accounts penalizes you. I don’t quite understand why there is a penalty for closing accounts. I shudder to think what would happen to my FICO score if I were to shutdown 100k of 130k in credit lines I have now.

Problem #5. Credit lines don’t appear to be indexed to inflation so if you start off with a $5,000 credit line in 2000 and inflation has grown at 3% then you’d think your credit line should have automatically increased to about $6200 “to be even” but credit cards don’t do this which means that your FICO score is gradually eroded as the load most people carry on their plastic gradually increases through simple inflation.

Problem #6. Too many people trying to game the system because of too much ambiguity. From “piggy back”credit card payment histories to various websites offering “tips” on how to improve your score, no one really knows what the formula is for FICO; the few “elite” that know how the system works game it and those who don’t suffer for it.

Problem #7. Opening new accounts or “too many” accounts penalizes you. Why? With BILLIONS of credit card offers going out each month with various rewards, gimmicks, prizes and such why are people penalized for taking advantage of them? Perhaps this should be called the “loyalty penalty” because if you switch to another bank with a new account, you’ll get slapped. This also ties into Problem #1 because you could argue that a person is opening a new account because they’re “running out” of credit but how do you differentiate between those going after gimmicks and those desperate for credit?

Problem #8. Debt accounts for 30% of your score but FICO doesn’t seem to differentiate between debt that can be easily paid off (e.g. arbitrage) , low interest debt used for cheap financing, or “desperate” high interest debt. Perhaps this could be solved by applying or displaying the interest rate somehow to all the revolving debt.

Problem #9. Types of credit in use account for 10% or so which I assume would mean that a “good” mix would be to have credit card loans, auto loans, and mortgage loans. What if I paid off my mortgage, only buy used cars (in cash) and only have credit cards to skim cash back? I’m penalized 10% for not having a “good” mix?

Problem #10. FICO is a number and people aren’t. Long before FICO, banks used have something called “branches” that were run by things called “people” who got to know other people called “customers” and the banking system revolved around the branch managers knowing their customers inside a community. Branch manager “Bob” knew loan customer “Sally” from the area and this “personal” interaction helped ensure that loans were made with a little something called “integrity” and “honesty.” There are hundreds of billions of dollars in bad loans out there so how does this bode for FICO?

Here’s a quote from myFICO website,

“myFICO is the consumer division of Fair Isaac, the company that invented the FICO credit risk score that lenders use. Starting in the 1960s, Fair Isaac sparked a revolution by pioneering credit risk scoring for the financial services industry. This new approach to lending enabled financial institutions to improve their business performance and expand consumers’ access to credit. Today Fair Isaac’s FICO score is widely recognized as the industry standard for lenders”

I wonder how the 151 lenders that imploded feel about FICO?