Flickr / Lending Memo.
When it comes to credit scores, the FICO scoring model by Fair Isaac Corp is the most widely used by lenders to determine the creditworthiness of prospective borrowers.
It was recently announced that some changes are taking place in the FICO model which are likely to boost the credit scores of millions of U.S. consumers. Are these changes for the better, or will they artificially inflate credit scores, giving loan access to consumers who shouldn't have it? And who stands to benefit most from the changes?
What's changing?
Basically, the FICO score will no longer include paid collection accounts, and will weigh unpaid medical collections much less heavily than it previously did.
So, if you have an old collection holding down your credit, as long as it's been paid, your score is very likely to rise once the new formula kicks in this fall.
And according to the Wall Street Journal, there are plenty of people in this situation. Out of the 106.5 million American consumers with some type of collection account on their report, 9.4 million had a zero balance.
The biggest impact should be seen in consumers where a paid collection or an outstanding medical debt is their only credit issue. If someone has a few late payments on current accounts in their credit report, for example, the removal of paid collections from the report will probably have less of an impact.
Aren't we asking for trouble?
One of the biggest causes of the financial crisis was credit being given to people who didn't deserve it. So, by ignoring some past credit behavior, aren't we artificially increasing the appearance of creditworthiness for some borrowers?
Well, yes, but not to the extent that it seems.
People who are really bad with credit generally don't just have a single issue (like a paid collection or medical debt) holding their score down. One paid collection item in an otherwise solid credit history usually doesn't drop a score into the "poor" credit level.
What this will do is make credit more affordable to a lot of people. According to one former FICO employee, the changes are not likely to be so drastic as to make the difference between approval or denial of a loan, but they may qualify borrowers for lower interest rates. This means that big-ticket purchases like homes and cars will become more affordable for a lot of people who until now have been forced to pay above-market interest rates.
The big winner
Banks are going to be the real winners here. Consumer lending activity is already performing very well, and giving more people access to credit at lower interest rates will provide yet another boost. Mortgage lending has been the one weak spot, as rates have risen and home values are about 27% higher than their 2012 lows. And, because of the long timeframes associated with mortgage loans, a small improvement in a mortgage rate can make a big difference.
Flickr / Mark Moz.
For example, according to myfico.com (where you can buy your FICO score), the average 30-year mortgage rate for someone with a 650 FICO score is currently 4.832%. If the new rules were to boost that score by just 20 points, the average rate drops to 4.402%. This may not sound like a lot, but on a 30-year, $250,000 mortgage, it makes a difference of more than $23,000 in interest over the life of the loan.
So, banks are likely to see more mortgage originations as reluctant homebuyers who suddenly qualify for lower interest rates come off the sidelines. And, as long as the banks lend responsibly by verifying buyers' ability to repay and requiring substantial down payments, a big increase in the default rate is unlikely.
