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Changes On The Credit Score Horizon

April 28, 2017
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Well, that was quick! As soon as we post a video about how your FICO scores are calculated (see video here), news breaks that there are major changes coming to credit scores!

In his article, which I've linked to here, Ken Sweet of the Associated Press reports that for certain types of debt, the three credit bureaus - TransUnion, Equifax and Experian - have started using a credit scoring method by VantageScore, a company created by the bureaus themselves. While FICO scores are still heavily used, VantageScore relies on 'trended data' to formulate a credit score by analyzing positive or negative trends in your spending. So, what does that all mean? Let's start with comparing the difference between trended data and the current FICO method, and then we'll review the impact VantageScore could have on your financial life.

Trended Data vs. FICO
There are many elements to improving your FICO score that can fly in the face of conventional wisdom. For example, you would think if you're trying to IMPROVE your financial behavior, closing a credit card that's been a big problem in the past would be an excellent step. But in terms of a FICO score, closing long-standing accounts actually hurts your score, because it lowers the average age of your credit. And in terms of FICO, the older your credit is the better. One might also argue that elements of your FICO credit score like Credit Mix actually encourage your to open more credit, as opposed to being responsible with the amount you currently have. More on that later ...

VantageScore's trended data aims to turn that model on its head, rewarding those who pay down or limit their debt and manage it effectively. To do this, rather than judging your score based on month to month activity, VantageScore projects potential positives or negatives that could arise based on your activity. For example, if you're paying down your debt, VantageScore would reward that trend by improving your standing. Conversely, if you're not currently overwhelmed financially, yet you continue to add credit that may be a problem down the line, this activity would reflect negatively on your score. Let's take a look at some major paradigm shifts:

Good, Better Best
Your credit score can determine a lot about your finances. The higher your credit score the more likely you are to be approved for credit, and the more likely you are to pay a low interest rate (and thus, less money) towards that credit compared to borrowers with lower scores. Many lenders have different categories that they lump borrowers into that are determined by a range of credit scores. People who meet the minimum requirements of a top credit group could qualify for better opportunities than another person whose score is extremely close to theirs but just missed the cut.  Here is an example of a breakdown of these categories for FICO and VantageScore

As you can see, VantageScore has different ranges that qualify borrowers for certain groupings, especially those on the lower end of the spectrum. This change could mean a borrower under a FICO scoring method could be considered in a different class of consumer than when they apply with a lender who utilizes the VantageScore.

Closing old accounts: FICO vs. VantageScore
As we covered, one element of a FICO score is that it can reward you for keeping old accounts open, even if those accounts have been detrimental in the past. VantageScore will treat this differently, choosing not to penalize consumers for closing old accounts. This change would mean that the age of your accounts, which makes up 15% of your FICO score, could look differently in terms of how you manage that history. FICO currently erases the years of a closed account from your credit age, which right now makes it unattractive. VantageScore does not penalize this behavior, which means understanding which scoring method a potential lender is using could determine how you handle old accounts when you're trying to improve your profile.


Paying down debt vs The 30% Rule
Credit utilization, or what percentage of your credit limit you're currently utilizing (or borrowing in layman's terms), makes up 30% of your FICO score. We've also covered a rule of thumb for this category, The 30% rule, which rewards you for keeping all of your debts within 30% of your credit limits. But while keeping your debts low is admirable, as long as they are within this threshold, FICO does not necessarily reward you for going the extra mile and paying off those debts completely. A person who maintains a balance on their account but never exceeds 30% of their limit could remain in excellent standing as far as FICO is concerned. But not only that, The 30% rule actually ENCOURAGES you to have high credit limits. For example, if Borrower A owes $1,000 on a card with a $2,000 limit (50% utilization), they technically look worse to FICO than a person who owes $2,000 on a card with a $10,000 limit (20% utilization).

VantageScore sees this formula as backwards, so they will instead penalize borrowers who take on too much credit, even if the amount they actually borrow is reasonable. Why? Because again, taking on increasing amounts of credit will be seen as a negative trend that might one day damage the borrower.

Civil Judgments, Medical Debts,Tax Liens
This is huge. Under the FICO scoring method, negative transactions, especially those related to poor payment history, can be a drag on your score for longggg periods. Under VantageScore however, medical debts, tax liens and civil judgments will be excluded from the credit score calculation completely. This decision follows a 2015 agreement between credit bureaus that acknowledged that not only are civil judgments more likely to contain errors, but also that many medical debts were being reported to consumers' scores before their insurance company had a chance to reimburse the claim.

It's important to note that just because VantageScore doesn't include these items in their formula does NOT mean they are erased from your credit report. Negative transations, unpaid judgments and bankruptcies can still stay on your report for 7-10 years. FICO and VantageScore are simply two different methods of using the information on that report to issue a credit score.

What Hasn't Changed?
While VantageScore might be gaining steam, FICO credit scores are still the standard for the time being. Most importantly, not only do government mortgage lenders still use FICO, but so do the majority of mortgage lenders. Because of its wide use, you don't want to completely turn your financial plan upside down to improve your VantageScore, especially if the habits you've built to improve your FICO standing is more likely to be rewarded. But, if you are concerned, ask any potential lenders what their method is for calculating your score when evaluating your credit. You may find that no changes are needed for the time being, but knowing what may lay ahead will better prepare you in the event that VantageScore is one day king of the castle.