Don't let a less-than-perfect rating hike your borrowing costs
Consumer credit scores are declining because of the recent recession. Continuing unemployment, falling home values, shrunken investment portfolios, and excess borrowing have made debt repayment more difficult for many Americans.
Approximately 1.2 million people have fallen out of the top credit-scoring tier of 800 to 850 since April 2008, according to a recent nationwide comparison by FICO, the Minneapolis company that invented credit scoring. At the same time, 2.2 million Americans have seen their scores fall below 600, long considered the lower limit of “prime” creditworthiness.
Lenders and insurance companies aren’t responsible for that credit-score deflation, but they’re exploiting it to boost their bottom lines. Banks tie borrowers’ loan qualifications and interest rates to their credit scores, and many have re-set their “subprime” score thresholds to 660 from 600 before the recession.
That shift means that the credit ratings of as many as 35 percent of adults might now be branded subprime, which burdens them with higher interest rates on loans than are charged to people with better scores. That’s a huge jump from 24 percent in April 2008, which we calculate means as many as 79 million consumers have subprime credit today compared with 53 million before the recession. And even if you’ve stayed above subprime, credit-score deflation might have moved you lower in that 190-point prime scoring range and higher on the borrowing-costs scale.
Credit-based insurance scores also play a major role in setting your home and auto insurance premiums in most states. That might partly explain why motor-vehicle insurance premiums, for example, jumped 10 percent from June 2008 to June 2010 compared with about a half-percent decline in overall prices during the same period.
You might think a reduced credit score is a punishment, and an unfair one at that. But the scoring industry says that lower credit scores spotlight consumers who have a statistically greater and provable risk of defaulting on their loans. Declining scores are an unpleasant fact of life for many in this recession. Fortunately, there are ways to deal with them. Here are three strategies consumers can use to fight back.
Shop harder for credit
One thing that the recession hasn’t changed is consumer choice. The large number and diverse types of lenders in the marketplace have different operating costs and business practices. You’re likely to find that your credit score will have a varying impact on the rates that different lenders might charge you. So it’s worth it to do some work to find the best deal.
Big savings can be found by shopping around for the best rate on an auto loan. “Car loans can be all over the board for the same credit score,” says Keith Gumbinger, president of HSH Associates, a Pompton Plains, N.J. company that publishes mortgage and consumer-loan information. Diligent shoppers can knock two to four percentage points off the cost of an auto loan, Gumbinger says. That can be worth $890 to $1,780 over the 48-month term of a $20,000 loan.
Shopping might also save you as much as one percentage point on an adjustablerate or jumbo mortgage. That can be worth $113,000 over the 30-year life of a $500,000 mortgage. Savings on conventional mortgages will be less, Gumbinger says, because they must meet Fannie Mae and Freddie Mac standards, and lenders have less control over setting the terms than they do when they keep loans in their own portfolio. Another way to save on borrowing when you have a low credit score is to get a mortgage backed by the Federal Housing Administration. Non-FHA loan rates start rising when a FICO score drops below 680, but “the FHA program has no penalty for a lower credit score,” Gumbinger says. “They lend at the same rate and terms all the way down to a FICO 580 score.”
FHA borrowers can also put as little as 3.5 percent down, but there are recently changed up-front fees of 1 percent, annual fees equal to 0.9 percent of the loan amount, and limits on the loan size and possibly on income. Limits vary by geography, so check with your lender.
Find cheaper insurance
Another possible cost of a declining credit score is higher auto and home insurance premiums. Most insurers now base a major part of their premium calculations on a consumer’s credit-based insurance score, a close cousin of the credit score. Almost all states allow that use.
In general, lower insurance scores produce higher premiums, because statisticians have found an association between lower scores and a higher likelihood of filing a loss claim. That, of course, is not the same thing as a higher risk of having an accident, and insurers have found no cause-and-effect relationship or any credible way to explain the connection. That’s one reason consumer advocates (including Consumers Union, the nonprofit publisher of Consumer Reports Money Adviser) have long argued that credit-based scoring is unfair and should not be used to set premiums. But legislative efforts in 27 states to ban or restrict insurance scoring over the past two years have been unsuccessful.
The impact of a reduced insurance score varies because different insurers use different methods to calculate scores and convert them into premiums—all of which are kept secret from consumers. But the solution for you is the same, no matter how the black magic works: If your insurer hiked your rate because of your score, vote with
your feet by shopping for a lower premium somewhere else.
Start by checking whether your state insurance department provides rate comparisons. Go to www.naic.org/state_web_map . htm to find a link to your state’s agency. You can also compare multiple insurers online at Answer Financial, Insure.com, InsWeb, and NetQuote. You usually won’t get an immediate premium quote online, but you will get e-mail messages from hungry agents. Also consider forming a relationship with an independent insurance agent, who can periodically check rates for you at a range of carriers.
Improve your score
Finally, there are steps you can take to improve your credit score and keep it from moving in the wrong direction:
Your score can be hurt by inaccurate information on your credit reports. So regularly check them by requesting a free copy each year from each credit reporting bureau at www.annualcreditreport.com . Beware of credit-bureau come-ons that promise a free credit report if you buy credit-monitoring services. They’re of little value. If you find errors, exercise your right to dispute them and have them corrected.
If you can manage it, paying down your credit balances is one of the most effective ways to improve your score, FICO says. The reason is that less debt owed reduces your credit utilization—the amount of your total debt as a percentage of your available credit lines.
The closer your revolving debt gets to your credit limits, the more your credit score suffers. So try to keep your creditcard balances low. And keep all of your other types of credit, including loans secured by collateral, within acceptable limits. Your monthly mortgage payment (including property taxes and home insurance) shouldn’t exceed 28 percent of your gross monthly income. Your total monthly payment on other, nonmortgage debt—car loans, credit cards, and personal loans— shouldn’t exceed 20 percent of your gross monthly income. About 30 percent of your FICO score is based on the amount of money that you owe.
If you’re behind on any credit payments, bring them up to date as quickly as you can and continue to pay on time. Contact the lender to explain your situation and how you plan to get current; prove it by making payments as agreed or according to new payment arrangements you’ve made. Ask the lender to “re-age” the account, which means you will still owe the principal and interest, but the account will be brought current for the record. Then live up to your part of the bargain.
Ask for a “goodwill correction”
Sometimes lenders will remove one bad mark from your account if you ask. So ask, especially if it’s an isolated smudge on your otherwise good payment record and you have a long-standing relationship with the creditor. FICO doesn’t track changes on your credit file, so if a negative item is removed by a creditor today, the scoring model won’t know it ever existed the next time it pulls your file.
Don’t close old credit accounts
It might be tempting to dump your creditcard company if it reduced your borrowing limit or slapped you with sky-high interest rates or unfair penalty fees. But closing a card account reduces your total credit line while the total debt on all your cards might remain the same. That increases your credit-utilization level, which depresses your score, especially if the account you want to close has a large credit line and a low balance.
If the account is old, closing it will also affect your score because a long credit history is a plus. Credit-scoring models “know” about your earliest credit experience by “seeing” old accounts on your credit report. Closed accounts eventually drop off your report.
If you hate the interest rate on your old credit account, it’s better to keep the card but use it sparingly and pay it in full each month. Use a lower-rate card if you have to carry a balance.
Talk with your insurer
If your auto or homeowners insurance rates have been increased because of changes in your credit-based insurance scores, your insurer should notify you and might have to make a free credit report available to you.
If your finances have been adversely affected by a recession, military deployment, divorce, loss of a job, death of a family member, or medical problems, ask your insurer for an exception in calculating your insurance score or applying it to your premium calculation. Also ask to be re-scored once a year so that you will benefit from any improvements.
Get help sooner rather than later
If you’re struggling to keep your head above water, the sooner you get things back in order, the better. Your score will probably take a negative hit, but it will be temporary, and each passing month after that your score will gradually recover if you stay on the right track.
A credit counselor can help you set up a five-year repayment plan with more favorable terms than you might be able to arrange on your own. If you go this route, beware of cons by companies that want to milk egregious fees because of your bad fortune. Seek out reputable, nonprofit agencies that employ trained and certified counselors who are members of the Association of Independent Consumer Credit Counseling Agencies (www.aiccca.org ) or the National Foundation for Credit Counseling (www.nfcc.org ). Also check the agency’s Better Business Bureau report.