The formula for calculating the most widely used credit scores will soon change to lessen the impact of bad medical debts and ignore old unpaid debts of any type that are later paid off.
Over time, the move is likely to raise some credit scores and loosen lending, meaning millions of Americans will have an easier time getting loans and better interest rates. However, it could be years before lenders adopt the new scoring system.
FICO, which says its brand of scores is used by 90 percent of U.S. lenders, said this week its new model offers “a more nuanced way to assess consumer collection information.” It ignores paid collection agency accounts and differentiates medical from nonmedical collection accounts.
“These are a couple of changes that are major,” said John Ulzheimer, credit expert with CreditSesame.com.
More than half of all bad-debt collections on credit reports are associated with medical bills, according to a study by the Federal Reserve Board.
The effect will be that medical debt turned over to collection agencies will still be a factor but have a lower impact on FICO's brand of three-digit credit scores. The median FICO score for consumers whose only major black marks are unpaid medical debts is expected to increase by 25 points on a scale of 300 to 850, according to FICO.
Even small increases in credit score can mean the difference between making the cutoff for getting a loan, though consumers whose only credit dings are medical debts probably already have decent scores, Ulzheimer said. So the difference might not mean approval or denial but getting better terms, he said.
Meanwhile, the new score for the first time will ignore old debts with a zero-dollar balance.
“It actually acts as an incentive for consumers to work with collection agencies to try to get their debts settled or paid, because they could see a considerable jump in their credit scores,” Ulzheimer said. A competing credit score by VantageScore Solutions already changed its model to ignore paid collections.
Credit scores attempt to predict the probability a borrower will pay back a loan. Consumers with the best credit scores also get the best loan terms, such as low interest rates, higher credit limits and lower down-payment requirements.
Those with poor scores might not be able to get a loan at all.
The FICO score change is most likely to affect applications for credit cards, auto loans, private loans, student loans and, eventually, mortgages, Ulzheimer said.
The bad news is that while the new FICO score will be available to U.S. lenders starting this fall, it might take years for lenders to adopt the new scoring system.
FICO's previous version, called FICO 8 and released in 2008, is just now reaching critical mass among lenders, Ulzheimer said. It's similar to the slow adoption in upgrading computers to a new operating system, he said.
“It takes time, and it's expensive for lenders to move off of older versions,” he said. So consumers who apply for credit cards in the near term, for example, are likely to be scored under the old model. Consumers can ask their lenders which scoring model they use.
Credit scores attempt to summarize in a single number information contained in consumer credit reports from credit bureaus, such as TransUnion, Experian and Equifax. The average FICO score is about 700, with consumers needing about 760 or higher to get the best loan terms, Ulzheimer said. The reports, but not the scores, are available for free once a year at AnnualCreditReport.com.
Experts say the FICO change seems, at least in part, to be a response to the Consumer Financial Protection Bureau, which in May released a research report claiming consumer credit scores may be overly penalized for medical debt that goes into collections.
An unpaid medical bill is different from other unpaid bills, such as those for phone service or utilities, the bureau argued. In some instances, the consumer may not even be aware of a debt sent to collections or that it is on his or her credit record, it said.
Medical debt can result from an event that is unpredictable and costly, and sometimes is caused by billing issues with medical providers or insurers.
“Medical debt is not something people choose to get into,” Ulzheimer said. “You didn't choose to get sick.”
Bad debts can be noted on consumers' credit reports for seven years, regardless of whether they are reflected in a credit score.
After FICO announced its change this week, consumer bureau spokeswoman Moira Vahey said, “Given the critical role that credit scores play in consumers' lives, we welcome steps by industry to adjust how it weighs medical debt in order to be as precise as possible in predicting the creditworthiness of a consumer.”Copyright © 2015, The Baltimore Sun