How The New FICO Scores Will Affect Consumers

How The New FICO Scores Will Affect Consumers

Every few years, car lovers rejoice when their favorite models are redesigned and improved. Like new cars, new formulas used to create credit scores are also released every few years, and the latest version of the FICO credit scoring formula has the personal finance world abuzz.

What are credit scores?

Dreamstime / Dana Rothstein

Dreamstime / Dana Rothstein

We all have a file being compiled on us by the three major consumer credit bureaus (Experian, TransUnion, and Equifax). These files were originally used just by lenders to determine our ability to repay a loan, but now our credit history may also be used to determine our insurance premiums and for some pre-employment screenings.

These credit histories can be many pages long, and can take an expert some time to determine who is qualified and who isn't. Eventually, lenders were able to streamline this process by having applicant's credit histories reduced to a single number called a credit score. That makes perfect sense, as who wouldn't want to use a simple number rather than spend time digging through the pages of applicants' credit reports.

How FICO 9 is different

FICO stands for the Fair Isaac Corporation and is the leading purveyors of the complex formulas that turn your credit reports into your scores. The exact formulas that FICO uses have always been a close secret, but they do disclose some basic guidelines.

Just as Chevrolet just released its seventh generation Corvette, FICO released FICO 9, the ninth generation of its consumer credit scoring formula. The formula is still a secret, but here is what we know about the changes.

For the first time, medical debts will be treated differently than other types of consumer debt. Apparently, analysts realized that medical debt is a poor indicator of consumer's overall ability to repay a loan. Perhaps this is because many medical debts are incurred when insurance companies fail to pay on-time.

In addition, the new version of the FICO scoring formula will not penalize consumers who have debt that has gone to collections, but has been paid off.

What FICO 9 means for you

These new changes are a win for consumers as a whole, who will eventually see their scores rise collectively. This will enable more people to borrow money at a lower rate, which some economists predict will stimulate the entire economy.

Yet there are several reasons that individuals should not be jumping for joy or changing their habits. First, these new changes will take years to penetrate the market. In fact, many lenders aren't even using FICO 8, which was released in 2009.

In addition, consumer's credit scores can still be hurt when they have medical debt or other bills that go to collections. Before an item reaches collections, it is often reported as being paid late, which by itself will hurt your credit score. Finally, when people apply for a home mortgage, the lender is still going to consider the entire credit history, not just the applicant's credit score.

These changes are good for consumers and the economy, but you should take the news as just another reason to be careful with your credit.

Get your credit score for free

All of this probably means very little if you don't know your credit score to begin with. You can get your credit score for free from a service like Credit Sesame, or check your Discover Card statement, which shows your current FICO credit score every month.