Touted as a solution for sluggish borrowing and perpetually low credit scores, a change to the scoring model used to determine those scores is stirring up some significant notice. Proponents of the new rules say that higher overall scores will stimulate borrowing. Critics suggest that the new model will tempt people who aren't responsible with credit with irresponsible borrowing.
How a Credit Score is Created
Fair Isaac Corp, the group responsible for the FICO score you see on your credit report takes your past borrowing behavior and gives your creditworthiness a number based upon whether you've been good or bad with loans, credit cards, and any other borrowing.
Unfortunately, the exact method Fair Isaac uses to determine that score is shrouded under the concealment of "proprietary" information. This means that Fair Isaac considers its method something akin to a secret formula. Like the ingredients of Coke or how they make McDonald's French fries.
According to Investopedia on FICO scores:
what is known is that the calculation is broken into five major categories with varying levels of importance…these categories are taken into account in your overall score – no one area or incident determines your score.
In descending order of importance, those categories include:
- Payment history
- Amount owed
- Length of credit history
- New credit obtained
- Type of credit used
One of the oddest parts about this score is that some credit is better than no credit. Your score will actually be lower if you don't have any significant credit obligations, so most credit score experts suggest having a credit card you occasionally use if you're not otherwise inclined to deal with borrowing and credit on a regular basis.
Today's FICO Scoring Changes
Historically, past failures to pay bills would significantly impact credit scores, and even if those bills were satisfied and paid the credit report wouldn't improve for several years when that satisfied debt finally became old news.
The change that will likely improve the credit scores of millions of Americans is that the FICO score will no longer take into account those old debts as long as they were paid or settled with a collection agency or the original creditor.
According to the official press release from Fair Isaac:
[FICO] announced today that the new FICO® Score 9 introduces a more nuanced way to assess consumer collection information, bypassing paid collection agency accounts and offering a sophisticated treatment differentiating medical from non-medical collection agency accounts.
This is a significant modification to the credit scoring model as it inspires a variety of changes in borrower behavior. First, debtors will no longer need to worry about their credit score going down after settling an old bill.
The phrase, "paid for less than the full balance" would often show up after a settlement was agreed upon between a debtor and his or her creditor, and a FICO score would tumble as a result, even though the debt was considered satisfied after the settlement was complete.
Interestingly, the credit scoring model dubbed the "VantageScore," which was introduced to compete against the FICO model, already introduced similar language into its scoring model. VantageScore is a number created through the cooperation of the three major credit bureaus: Experian, Equifax, and TransUnion.
However, adoption of the VantageScore hasn't been universal, and not all major lenders use the new type of score when deciding whether to approve or deny credit.
According to an article on CNNMoney in 2013,
Currently, debts that go into collections, even if they are paid off, are factored into all credit scores for up to seven years…But VantageScore 3.0 will no longer factor these accounts into a consumer's score if the debt was paid in full or settled, just as long as the balance is zero.
This 2013 change is almost the same modification just announced by Fair Isaac in 2014.
Hope for a Boost to the Economy
After the close of the recession, which still feels as though it's in full swing for many Americans, lenders found themselves chastened by the public, who accused them of predatory lending practices.
Unfortunately, the billions lost by banks, the major financial failures, and the mountains of written-off debt led banks and lenders to refuse applications from anyone but those with the highest credit scores. According to an article from "The Wall Street Journal," the new change was the result of months of talks between the Consumer Financial Protection Bureau and lenders.
The changes are expected to boost consumer lending, especially among borrowers shut out of the market or charged high interest rates because of their low scores.
One of the biggest costs of borrowing is the amount of money paid on interest. According to numbers published by the WSJ, over 106 million people had a collection account on their report, but over nine million of those people had zero balances on those accounts. Those nine million borrowers will benefit from the new rules.
Experiencing Credit Problems? Don't Know Where to Turn?
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