The nation’s premier credit scoring agency, the Fair Isaac Company, has come to an agreement with the Consumer Financial Protection Bureau to change the way credit scores are calculated. It’s a move that could boost lower end scores by 25 points or more by ignoring certain kinds of bad debt.
And that, financial experts fear, could create a landslide of bad debt, as risky borrowers are suddenly able to qualify for loans they can’t actually pay off. That scenario raises the specter of another economic collapse like the one that hit the housing industry back in 2008.
Why the Changes?
The housing crisis of ’08 put the spotlight on a bevy of bad practices on the part of both lenders and borrowers. As the housing bubble began to expand, banks made home loans available to just about anybody who asked. Adjustable Rate Mortgages made initial payments low and easy – and many borrowers didn’t understand that that could change dramatically in a few months or years.
Then the crash happened. Homeowners fell behind when those balloon payments came due. Houses everywhere fell into foreclosure. And the nation’s big banks were caught in a variety of fraudulent practices, including faking foreclosure paperwork and lying to customers.
All that led to the implementation of some wide-ranging legislation to try to keep it from every happening again. The Dodo Frank Act took effect in 2010 – an attempt to protect consumers by imposing tighter lending standards and penalizing banks that chose to keep writing loans that fell outside the provisions of the new Qualified Mortgage Rule.
But those standards locked many borrowers with lower credit scores and trouble meeting down payment requirements out of the process. The result? Far fewer loans for major purchases such as home buying – and that raised worries about the future of the economic recovery.
Enter the Consumer Financial Protection Bureau. Created under the provisions of the Dodd Frank Act, the CFPB’s job was to do exactly as its name says – to protect people from bad and misleading financial practices and to help borrowers in trouble.
Now, in a move that ironically reverses tenets of the Dodd Frank Act that created it, the CFPB is asking FICO to loosen its standards to allow more people with blights on their credit report to qualify for mortgages and other kinds of loans. It’s a move that, the government hopes, will jump-start the sluggish housing market and the economy as a whole.
FICO’s New Moves
FICO scores set the standard for most borrowing the US. According to a recent Huffington Post article on the CFPB’s actions, over 90 percnet of all loans in the country are based on FICO scores. Those scores help lenders set interest rates and determine their own level of risk. They’re also used by employers as part of the hiring process.
Fair Isaac is not a government entity – but in this case it’s changing major parts of its credit scoring process to address the CFPB’s concerns. Those involve:
Bad debt discharged through collections. If a borrower clears an unpaid debt through an arrangement with a collection agency, that debt won’t be a factor in calculating the FICO score.
Medical debt. It’s well known that medical debt, especially hospital related debt, is one of the leading causes of bankruptcy in the US. Under the proposed FICO changes, medical debt would have less impact on credit scores. And if it’s the only debt a person has, their score might jump 25 points or more.
People with skimpy credit history. It’s always been true that the less debt you have, the more of a credit risk you are. Now, FICO is implementing new ways to calculate creditworthiness for people with little credit history, so that they can end up with a higher score.
The changes to FICO’s scoring system are intended to directly affect those who have been denied credit in recent years because their scores fall below the cutoff point for what lenders have determined to be safe lending.
That should open doors for these marginal borrowers to qualify for loans to buy homes and other big purchases, which in turn would jumpstart the economy. Advocates of the changes, which include consumer advocates as well as financial professionals, praise the move as a way to encourage more participation in the economy and help people build stability and security.
But critics of the move argue that the change in scoring is nothing but a numbers game. The higher scores borrowers would have under the new system don’t actually reflect an improvement in their ability to repay a loan – and ignoring bad debt cleared through collections won’t make the borrower’s behavior improve next time around.
That, they say, could create a backlash that forces lenders to tighten standards even more, or raise interest rates. Another housing crisis could hit as risky borrowers default again, with conseque3nces for the economy as a whole.
The changes to FICO”s scoring system won’t take effect until this fall, so it’s too early to tell which scenario will play out. But the CFPB’s plan to change the borrowing landscape has the potential to affect borrowers everywhere – even if their own credit is sterling. (Featured image: Flickr/JanetRath)
Frankle, Neal. “How Upcomng FICO Credit Score Changes Might Rock the Economy.” The Huffington Post. Huffpost Business. huffingtonpost.com. 26 Aug 2014
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