You’ve heard stories about the wealth gap, the gender pay gap and even the income gap at large, but now due to a recent credit scoring change, you may officially live in the world of credit score gaps.
Fair Isaac, the company behind FICO scores, is changing how credit scores are calculated, thus affecting who gets a loan and who doesn’t. And while many consumers are not going to be happy with the results of the change, the changes are being made to help prevent consumers from getting crushed when the economy swings in the less preferred direction.
Here’s what I’ve learned in over 20 years in the financial industry — people care way too much about their credit scores and people hate being told no.
Your credit score helps financial institutions determine whether or not they want to risk loaning you money. Theoretically, if you have a high credit score, there’s just a small chance you won’t be able to pay the lending institution back and on-time. While if you have a lower credit score, it’s more likely you may struggle to pay the lender back and on-time. These are the basics.
However, over the last 30 years or so, something strange has happened. Americans have conflated the ability to borrow with financial success. When a person has a high credit score, they often convince themselves the high credit score means they’re financially healthy. Nothing can be further from the truth. Can they more easily qualify to buy a home? Sure. Does the ability to buy a home make the decision to buy a home a good financial decision? Absolutely not.
Believe it or not, lenders want you to borrow, even when you objectively shouldn’t. This is a surprisingly tough concept to understand. There is an amount of money you objectively should borrow, and the bank will let you borrow that amount. There is also an amount of money you objectively shouldn’t borrow, and many lenders will let you borrow that amount too. In fact, lenders encourage you via marketing campaigns to borrow money you shouldn’t objectively borrow. They know you hate being told no, and they are going to lend you money until they are absolutely forced to tell you no.
While I don’t agree with this approach to lending, I don’t necessarily blame the lenders. Borrowers must understand the difference between what they can and can’t afford to borrow. Just because I’m allowed to eat at an all-you-can-eat buffet for four hours, doesn’t mean I should.
So here’s the good news that might bother you.
With the new scoring system, FICO scores will be more difficult to maintain for those with moderate to poor finances, while consumers with good scores will benefit greatly when they continue to exhibit excellent credit behavior. The result will be a wider credit score gap for the haves and the have-nots. This will undoubtedly infuriate people.
For years now, lenders have been trying to grow their pool of borrowers. This is not unique. Lenders do that from time to time. But now lenders have indicated they’re looking to remove excess risk from the same pool they just grew. Why? One theory suggests the popularity of using personal loans to payoff credit card balances has led to an increasing number of borrowers running their credit card balances right back up, while still owing on the personal loan. As you can imagine, these increased debt levels lead to late payments and, eventually, defaults.
As consumer habits evolve, so must the standards in which the risk of borrowers must be evaluated. The prevalence of the credit improvement industry is, at times, nothing more than tricking lenders into thinking you’re a lower risk than you really are. When this happens, the lender isn’t the only entity that ends up with the short-end of the stick. The borrower suffers too.
I remember speaking to a man with $90,000 in credit card debt who wasn’t at all alarmed because his credit score was still high and “if the bank thought (he) was in bad shape, they’d deny (him).” Minutes later he told me the $4,000/month minimum payments were crushing him.
You must separate your credit score and your financial health. If you don’t, you can be tricked into ruining your financial stability.
The new credit score changes will actually protect out of control borrowers from themselves. However, the protection will come in the form of the word “no,” therefore it won’t be well received.