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A New Credit-Scoring Model and What It Means

March 19th, 2015 | adminT | Tags: , , , ,

It’s called FICO 9.  That’s the descendant of FICOs 1 through 8, the credit scores spawned from the Fair Isaac Corporation, the credit-scoring company.  The FICO score, a number between 300 and 850 that many lenders use to judge the creditworthiness of prospective borrowers.  The higher the better for borrowers since a higher score can result in a lower interest rate and possibly better loan terms.

Jim Wehmann, executive vice president for scores at Fair Isaac, is quoted in a Fair Isaac news release as saying “FICO Score 9 uses a more refined treatment of consumers and those with accounts at collection agencies, so that lenders can grow their credit and loan portfolios more confidently.”  What Wehmann left out there was a lower penalty for overdue medical bills. The net result will be FICO-score increases of up to 25 points for some people who benefit from these changes.

Fair Isaac reports that the FICO score is used by “90 percent of all U.S. consumer lending decisions,” and that 25 of the “largest credit card issuers, 25 of the largest auto lenders and tens of thousands of other businesses.”  Of course, Fair Isaac is encouraging all of them to use the new scoring system.  That could be something of a problem because mortgage lenders are using a FICO scoring system two versions old.

This change is a partial “Pass Go” but only collect $100 for people who are having problems with medical debt, and there are many.  Experian, the credit bureau, says that as of July 2014 64.3 million consumers in the U.S. had medical collections.  It’s also a partial pass for people who have paid collections.  Experian also reports that 106.5 million consumers have collections on their reports, but that the 9.4 million who have no balance, that is a paid collection, will not be penalized.

It’s also credit invitation for people who have a limited credit history, mostly 19 to 29-year-olds.  Those are the people who have “thin files,” that is, limited credit histories.   They have fewer credit cards and less credit-card debt than does the rest of the population, which has more cards and almost twice the average balance on cards.  The 19-29-year-olds are the ones who have most of the student loans, and with the looser credit scoring will have the opportunity to borrow even more money.

What we’ll look at here are the possible effects these changes might have on people who already have excellent credit and what to do to balance or discount the ill effects of the scoring change.

Greg McBride, the chief financial analyst for Bankrate, the financial services company, says these changes won’t provide much if any help for people who already have good credit.  Suppose someone already has a “great” FICO score of 725.  The person with a good score of 700 could instantly get bumped up to 725 because of the medical bills he owes but are now discounted on the FICO scoring.   That’s good for them but no good at all for the person who has had the 725 all along.

The result for lenders will be that they end up discounting the credit scores all around.  That 725 might get the same treatment as a 700 did before.  Mind you 700 is considered good but 725 fetches a lower interest rate.  So now the 725 becomes the new 700.

What does that mean for those who look at credit reports for employee and tenant selection?

First, ignore the FICO score.  What is most important is the debt-to-income ratio, that is how much money coming out divided by how much money coming in, the amount of money that doesn’t have to go to pay bills.  So, for example, if someone has contracted debts that require payments of $3,000 per month and his or her income is $3,000 per month, that’s a debt-to-income ratio of 100 percent.  Raise that monthly income to $5,000 a month, and the debt to income ratio is 3000/5000 or 60 percent.  Raise the monthly income to $7,000 and the debt to income ratio is 3000/7000 or 43 percent.

The less disposable income, the greater the risk of default because unexpected things do come up, such as car repairs and medical bills.

Second, look at how many, if any, bills are past due.  You judge what is acceptable for your own situation, but numerous past-due bills can turn into collections, which can turn into judgments, which can turn into garnishments, thus making an employer have to deal with payroll issues or a landlord not getting the rent because there’s not enough income left over to pay it after food, utilities and other bills.

Fair Isaac has waved its magic wand, intoned an incantation, and had its computers come up with a different way to assess creditworthiness.  It’s all in an attempt to sell more of its product, of course.  That’s good for them, I suppose, but maybe not so good for people with good credit, for lenders, for prospective employers, and for landlords.  Our own judgment most likely works better than a number created simply to enable more people to get more credit.

By Robert L. Cain

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