Recently, there has been a subtle shift in the way FICO scores your credit. You may not notice this change and you may not even think it’s important. But it’s something you should care about if you own property. This is especially true if you were planning on using real estate to fund your retirement. This new FICO scoring criteria could bring about very nasty market conditions for real estate owners.
What’s Going On?: FICO isn’t going to ding people with specific blemishes on their credit history anymore. There are three events that used to hurt people’s scores that no longer do:
- If they had a debt written off and then paid it.
- If they have little credit history — or none at all.
- If one or more of their medical bills were written off.
A Little Background — What is a FICO Score?: FICO scores try to assess how financially responsible people are going to be based on their credit history. They are provided by a private company by the name of Fair Isaac. This company has been calculating and selling consumer FICO scores since 1989. They’ve done a pretty good job and their data is used by over 90 percent of the financial institutions in the United States. The reason that so many financial institutions rely on FICO scores is because they are very accurate predictors of future financial behavior and risk. Businesses use the sores to decide whether or not to advance credit to consumers.
Why is this happening?: The Consumer Financial Protection Bureau “negotiated” with Fair Isaac to change the way they calculate FICO scores. As the CFPB saw it, too many people were locked out of the credit market because of their past. Because FICO took points off for past credit hiccups, those people were unable to get mortgages or credit cards. Even if they did get credit, they had to pay higher interest rates because of their past. (In addition, FICO scores are often used by would-be employers and consumers with tarnished credit found it more difficult to find jobs. That was also something the Consumer Financial Protection Bureau wanted to change.) With the new criteria that FICO uses now, millions of Americans will see their credit score jump up to 25 points. Those extra points will make a big difference. Many of those people will get credit they were otherwise unable to obtain.
What Will Be The Fallout?: On the face of it, this might seem like a good thing. What’s wrong with helping people get a mortgage?
In my opinion, there is plenty wrong with it. Of course nobody knows what the future holds, but I can’t see how this change helps anyone. Keep in mind that FICO scores are the most respected credit score on the market. They are used globally because the scores are good predictors of risk as I said before.
This change artificially inflates scores but it doesn’t change the risk that the banks will have to take. It’s true that more buyers may push prices up initially, but that may be a short-lived phenomenon.
Remember, these people had bad credit scores because they posed higher risks to lenders. The chances are high that their default rate will be the same as it ever was. So more people will be given loans they can’t afford. When they default, they’ll lose their down payment and end up with an even worse credit scores too. If those defaults pile up, it will hurt everyone; property owners, banks, construction workers — you name it.
Of course the law of unintended consequences is always at work. It’s possible that this could turn out to be good — although I don’t see how. It’s also possible that the banks will find a way to impose strict guidelines to make sure they don’t make the risky loans the Consumer Financial Protection Bureau wants them to make.
Even if the banks are forced to make these loans, it will take some time before the inevitable defaults and foreclosures start cascading in. That’s why it’s important for real estate investors to be aware of these FICO score changes and to keep their eyes on how this plays out in the real estate market.