On Wednesday July 21 President Obama signed a massive financial overhaul. Some are calling this FinReg and some are calling it Dodd Frank. Regardless of what it's called, FinReg accomplishes a major win for consumers referred to as the FACS Act. The FACS Act is the Fair Access to Credit Scores Act and it guarantees that consumers who are denied anything because of their credit scores, including a better interest rate, will get a copy of the actual score that was used to make the decision.
While the implementation date of the free score disclosure rule is still to be determined, it won't come a moment too soon. FICO scores have plummeted more over the past 3 years than they have over the previous 17 years due to the mortgage meltdown and a 10% unemployment rate. This means a higher percentage of credit applications will be denied over the next several years because not only have scores decreased but underwriting standards have increased, further separating applicants from approvals.
FICO scores have been around since 1989 and their distribution has remained relatively unchanged since then. The two primary reasons for this are the size of the credit bureau databases, 200 million credit files, and the fact that we haven't seen the confluence of so many significantly influential economic events.
Until the beginning of the recession roughly 15% of the population that had a score had one below 600. Now, as of April 2010, 25.5% have scores below 600. This is an increase from 30 million to 51 million. And more importantly, the percentage of consumers who score below 650 has gone from 27% to 35%. This means at least 70 million consumers have FICO scores below 650 and are now considered either subprime or at the very least "of elevated credit risk."
The question now becomes, what will these people do now that their scores are so low? Some people would have you believe that the dramatic plunge of FICO scores is because of credit card debt. That couldn't be further from the truth. Credit card debt doesn't cause your FICO scores to plummet into the sub-600 region. No, this kind of credit degradation is caused by negative credit events hitting consumer's credit files. Bankruptcy, collections, late payments, charge offs, foreclosures, short sales, settlements, these are the types of events that cause such score damage.
Unfortunately these negative events will remain on credit files for the allowed statute of limitations, which is 7 to 10 years depending on the event. This means the new lower score distribution will remain as such for the foreseeable future. And it also means higher interest rates, lower credit limits, more expensive insurance and difficulty in getting employment as long as your prospective employer relies to some extent on credit screening.
It does mean that fewer consumers will be able to use mainstream lenders for their credit needs. It also means that lenders who target the super-subprime will have a busier than expected few years. These companies are the pawnshops, title lenders, and payday lenders. Unfortunately none of these lenders report your payment activities to the credit reporting agencies. This means consumers who rely on them for their credit needs will not benefit even if the short term high interest loan is properly managed. This could lock in a cycle of lower scores for millions of consumers.
With unemployment at 10% and under-employment at, or above 16% fewer consumers will be able to pay their way out of poor credit. This will require an alternative strategy that depends largely on avoiding all credit for years while you put time between yourself and the negative credit events that are causing the lower scores. Normally this is not a wise strategy because FICO scores like to see new, good items to help offset the damage being caused by older negative items. The problem is that the price of using credit with scores so low is simply too expensive.
It also means that bankruptcy could become the best choice as it will protect you from your creditors, and get you largely out of debt assuming you qualify for a chapter 7 rather than a chapter 13. The bankruptcy will remain on your credit reports for 10 years from the filing date but it will wipe away the debt owed to collection agencies and your creditors. This will prevent additional negative information from hitting your credit files while you're trying to dig your way out of the FICO basement.
The news isn't all good for those of you who have maintained or achieved elite FICO scores above 800 at the same time so many have seen their scores drop to all time lows. Lenders are not only looking for better credit risk but they're also looking for customers who will generate revenue. Unfortunately more and more lenders are recognizing the fact that consumer with extraordinary FICO scores are also less likely to depend on credit and do things like revolve balances from one month to the next.
This has resulted in lenders actually declining applicants if their scores are too high. This will give the impression that lenders don't know what they're doing and that consumers are being treated unfairly. And, in a bit of ironic humor, consumers who are declined because of FICO scores being too high will also get to see their scores because of the denial. Can you imagine getting an adverse action letter from a lender stating that you were denied because of your FICO score just to find out that your FICO score is 825? The world of credit is not without humor.
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Matt
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