THE BLOG
08/25/2014 11:40 am ET | Updated Oct 25, 2014

How Upcoming FICO Credit Score Changes Might Rock the Economy

Will FICO Score Changes Smack The Economy, Real Estate and The Stock Market?

Starting this fall millions of people who up until now had lousy credit scores could see their FICO ranking dramatically improve almost overnight. As a result, they may have access to credit that was otherwise unavailable to them. Is their FICO score rising because they are all going to get together and make good on their past collective bad debts? No. This is happening because the Consumer Financial Protection Bureau negotiated with Fair Isaac (the company that generates FICO numbers) to change how they award points.

This is an important development for everyone regardless of what your credit score is. The aftermath of this change could be felt in the banking industry, the real estate market and it could even force interest rates higher. And that's just for starters.

What Is Happening?

There are three dramatic changes that will inflate FICO scores:

1. If someone had a bad debt they later paid off through collections, that bad debt won't affect FICO scores anymore.

2. Any debt relating to medical problems will have less impact on scores. In fact, if the only bad debt someone has relates to a medical problem, those people might see an increase of 25 points or more in their FICO numbers.

3. Fair Isaac will evaluate people with little credit history using a new algorithm that will give them a higher grade.

How Are FICO Scores Used?

FICO scores are widely used by banks, financial institutions, credit card issuers, auto and other lenders. According to Fair Isaac, 90 percent of all loans made in the United States rely on the borrowers' FICO score to determine if the loan will be made and if so what the appropriate interest rate will be. Many employers also consider FICO scores before hiring employees.

Fair Isaac's FICO scores are ubiquitous. The company has been providing credit scores since 1989 and has developed a very accurate creditworthiness gauge. This may not be nice to say but if FICO says you aren't a good risk you probably shouldn't take the loan even if someone is willing to give you the money.

Up until now, FICO has been the industry standard. But now the government is directing the firm to change their methodology.

Why Are These Changes Being Made?

The government feels that many low income individuals and minorities are shut out of the real estate market and denied credit unfairly because of past blemishes on their credit history. They hope this change will allow more of those people to buy homes and obtain more credit.

Who Does This Help?

You might think that this change will help people with low credit scores. I'm not so sure. FICO scores are supposed to reflect the risk that financial institutions take when they extend credit. This change inflates scores but it doesn't change the risk to the lender. Sure there will be some people who will be able to afford these loans but many will not if history is any judge.

The Potential Pitfalls

As I explained above, the market has voted and named FICO the most reliable and useful credit evaluation tool there is. If that goes out the window and lenders are forced to make loans to people they otherwise would not loan to, defaults could rise. That means many of the people this is meant to help actually get hurt. It also might damage the real estate market and the overall economy if things get out of hand.

The Bottom Line

It's difficult to say how this change in FICO score ratings will play out. Banks could tighten their lending standards or sue the government and tie this up in court. But this is an important news item to watch and consider as you make investment and real estate decisions going forward.

Are you concerned about this change in FICO scoring? Why or why not?

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