FICO is changing the way they calculate credit scores. For many people, that means scores are going to go up. You might think this is great news but as you’ll see it may not be. In fact, it may be a terrible development. And this is something you need to be aware of even if you don’t care what your credit score is.
Am I just a party pooper unable to enjoy a windfall that others are about to receive? I don’t think so but I’ll let you be the judge of that.
What’s Happening?
During the 3rd quarter of 2014 FICO is going to stop penalizing people for specific events that up until now hurt their credit scores. FYI – FICO is the biggest credit scoring company in the USA so this is important. The result will be that millions of people will be eligible to get loans they were unable to get before this adjustment.
There are basically three negative historical events that will no longer hurt people as they once did:
- If they had a medical bill which they didn’t pay and was written off.
- If one of their debts went to collections and they later made good on it.
- If they have little or no credit history.
It turns out there are millions of people who will be impacted by this change. And according to The Consumer Financial Protection Bureau many of those millions of people will get a bump in their credit score by up to 25 points. Those precious points can make the difference between getting a mortgage and not getting one. And that’s what’s so frightening. But we’ll get to that a little later.
Why Is This Happening?
The Consumer Financial Protection Bureau “negotiated” with FICO and other credit score rating firms to make these changes. This government agency feels that people with these three blemishes in their credit report are unfairly denied access to credit and mortgages and hence unable to fully participate in the American economy by getting credit despite their past. The government worked with the credit scoring companies to make these changes in order to improve scores and thereby make credit more available.
How Are FICO Scores Used?
FICO scores are used by over 90% of the financial institutions in the United States as I said above. Usually, these banks and other companies decide whether or not to give you credit based (at least in part) on your FICO score.
It’s true that this development is going to improve some people’s FICO scores. But it won’t change the underlying risk banks take when they sell mortgages. That means more people will get loans they really can’t afford.
I am not saying that people with tarnished credit histories are bad people. It’s just that FICO is the “go to” credit scoring firm for a reason. They have this figured out. They have followed billions of transactions since 1989and they know statistically who is and who is not a good credit risk based on past financial behavior. Are some people denied credit now that would be good for the debt? Absolutely. But in the big picture, FICO scores are very reliable. That’s why almost every lender uses them.
But if this change takes place it’s likely that many people will be given loans they will later default on. That will hurt the people who default on those loans, the banks, other property holders and the entire economy.
Bottom Line
We’ve been here before. Banks gave loans to people who couldn’t afford them and the result was not pretty. In 2006 the real estate market started a long and painful decline when those problems came home to roost and that in some part caused the Great Recession of 2008.
I can’t foretell the future and sometimes the law of unintended consequences works out for the better. I’m not in the business of predicting the future and I don’t know what’s going to happen. So maybe I’m all worked up over nothing.
While this is not a positive development (in my view) it will take several years left unchecked for this issue to have a deeply negative impact on our economy. That gives FICO, banks and the regulators time to get this right.
I hope that’s the case. It’s good for everyone when people get loans they repay. But nobody wins if people get loans they can’t pay back.
What can investors do? Keep your eyes open. Watch what’s happening to real estate markets and don’t get caught up in the speculation that may accompany this change.
Are you concerned about changes in FICO scoring? Why or why not?
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