If you have experience borrowing or lending in the U.S., you likely have a sense for the importance and widespread use of credit scores. Recently, Prosper announced that it would upgrade its credit score from Experian ScoreX Plus to FICO® 08. In this post, we will explore what a credit score is, why there are multiple versions of credit scores, and how this change is reflected in Prosper’s loan listing data.
In the most general sense, a credit score is a mathematical algorithm that attempts to quantify the risk that a borrower will default on a loan obligation. This algorithm is often calculated using information from the borrower’s credit bureau, including but not limited to payment history, amount owed, length of credit history, new credit inquiries, and types of credit used. Upon receiving a loan application, most U.S. lending institutions will purchase credit scores from one or more of the 3 major bureaus – Experian, Equifax, and TransUnion. As it is possible for each bureau to contain slightly different data, a borrower’s scores may differ from bureau to bureau.
In addition, many lenders will also utilize their own internally-developed credit risk models (as do both LendingClub and Prosper). Internal models offer the lender a chance to create a more precisely calibrated score for 2 main reasons. First, such a score can incorporate not just the aforementioned credit bureau data but also data received from a borrower’s loan application, other data that the lender may have on file (such as prior loan performance), or other external datasets. Second, the score can be built and validated specifically on that lender’s specific product, while bureau-derived scores are built on a much broader population.
When most people refer to their “credit score”, they typically have one number in mind, when in reality, there are numerous scores used for consumer lending, all with their own differences. The best-known credit score is the FICO Score, first developed decades ago by a company then called Fair Isaac & Co. and now re-branded simply as “FICO”. The score has a range from 350 to 850 (higher score=lower risk) and is transformed on a “log scale”. This is a fancy way of saying that the difference between 750 and 770 is not the same as the difference between 730 and 750. The FICO score has been continuously improved over time based on new data and better analytic techniques, with the most recent version known as “FICO® 08”.
The FICO Corporation licenses its score to the credit bureaus, which must pay a royalty each time the algorithm is calculated. For this reason, the bureaus have also developed their own models to generate a similar score without having to rely on FICO. Due to the lack of royalties, bureaus are able to offer these non-FICO scores to lenders at lower prices. Examples include “Vantage Score”, “TransRisk”, and “ScoreX Plus”, the latter of which was used by Prosper until their recent shift. When you go to websites such as CreditKarma to check your score for free, you are in fact seeing TransRisk.
We view Prosper’s recent score upgrade as a very positive improvement. In their blog post, they mentioned that FICO® 08 is the widespread industry standard and also that the new score would allow them to more precisely assess a borrower’s risk, which should benefit investors.
Since Prosper is still making both scores available through its API for the time being, we decided to take a look at a snapshot of information from the most recent 2,000 listings on the platform.
The graphs below show the distribution of the 2,000 listings across ranges of each score. As you can see, the FICO score has more of a bell-curve distribution, whereas ScoreX is skewed rightward. Already, we can see that FICO and ScoreX must be different.
This next set of charts shows the distribution of listings by FICO® 08 for each band of ScoreX. For example, the topmost chart shows listings with ScoreX between 640 and 649 and how they are distributed among the range of FICO® 08 scores. We can see that while the 2 scores are generally correlated, there is quite a bit of shifting happening in each band, indicating that the change may have a sizeable impact.
As a lender, it is good to understand which scores are being utilized to underwrite your loans. Prosper’s move to FICO® 08 is a positive step for investors in that platform as well as for the industry as a whole. Given the charts above, we expect that loans underwritten by Prosper under the new scoring regime will have more consistent performance within each alphabetic rating, which ideally will result in better rates for borrowers as well as more predictable returns for investors.
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