FICO scores, which have become key to just about everything from renting an apartment to obtaining an auto loan, will be undergoing big changes this year. The new upgrade, called FICO 9, will roll out this fall, affecting millions of Americans.
But what exactly is a FICO score. FICO scores are a type of credit score widely used by banks, financial institutions, credit card issuers, and other lenders as a key component in a consumer lending decision. The scores are meant to predict the likelihood of default, and generally, the higher the credit score, the more likely that person will repay the lender on time. 90% of all loans made in the U.S. use FICO scores to determine if a loan will be made and if so, what the interest rate will be. That's why the upcoming changes are so critical--and understanding them could potentially save you thousands of dollars.
The main change to the FICO methodology is that the new score will no longer weigh medical debts as heavily as it did before. Any debt relating to medical problems will have less impact on scores.
This is big news because this May, a Consumer Financial Protection Bureau study found that consumers are overly penalized with higher interest rates for medical debts that go to collections. For borrowers whose only major negative credit file blemish is an unresolved medical debt, the new model will increase scores by around 25 points .
Consumers whose credit files are tarnished only by unpaid debts that went to collection agencies--but were ultimately either settled or paid--can expect to see a big increase in their credit score of 100 points or more. With the new methodology, if you pay off a collection debt so that it shows a zero balance, it won't hurt your FICO score. FICO 9 forgives you once you make things right with the collections agency and pay the balance.
No Credit? No Problem
The new FICO score evaluates potential borrowers with little credit history using a new algorithm that will give them a higher score. The new score is designed to more fairly treat applicants who have limited credit histories--like young, first-time home buyers or consumers who have made little use of credit cards.
So, What's The Impact?
The impact of the changes could be huge solely based on the number of people affected. As of July, 64.3 million consumers showed some level of unpaid medical debt on their credit reports. And of the 106.5
million consumers contacted by collection agencies last year, 9.4 million had zero balances left on their accounts and would not be penalized under the new FICO 9.
Higher FICO scores could help those affected secure better loan rates, potentially resulting in thousands of dollars in savings. Even a small difference in credit score can change the interest rate that borrowers receive. For example, a consumer with scores above 760 points could receive a 30-year mortgage loan at 3.75%. For consumers with scores at 700 to 759, that jumps to 4.00%. The difference is especially prominent with car loans. Consumers who have high FICO scores in the 720 to 850 range currently get an average interest rate of 3.24% on 36-month car loans. That interest rate jumps to 4.65% for borrowers in the 690 to 719 range. A borrower who jumps from a score of 600 to 700 could save around $4,600 in interest charges over the life of a 36-month, $25,000 car loan.
But the new FICO score doesn't just raise scores- FICO says that the new model will more fairly rank the actual risks posed by loan applicants. The changes could help those who are currently shut out of the real estate market or denied loans, allowing more people to buy homes and qualify for more credit. For lenders, any loosening of credit standards raises concerns that the changes could open them up to more risk or tempt precarious borrowers deeper into debt. Since the housing bubble and subsequent recession, lenders have been hesitant to create another debt bubble.
However, FICO's ultimate goal is to raise credit scores for tens of millions of Americans and boost lending without opening lenders up to more risk. If it works, the FICO score changes could have positive effects on the U.S. economy.
When Are These Changes Happening?
The new credit score system will take a while to implement as financial institutions and lenders recalibrate complex automated underwriting systems. In fact, it may take years to fully see the impact on the greater economy as lenders adopt the new system.
In the meantime, you still have the power to boost your credit score the old-fashioned way, by practicing healthy credit habits. Paying your bills on time, building a credit history early, paying off credit cards each month and applying only for the credit you need can also help improve your FICO credit score--and save you money in the long-run.
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.