Credit scores are changing and for a lot of borrowers that means better numbers, lower rates and the chance to get bigger mortgages.
FICO -- a credit scoring pioneer and one of the most-important providers of scoring services -- says it will reduce the weight and heft given to medical debts and so-called thin files, credit records which show few items. The new rules should raise scores for millions of potential borrowers.
So how do the new rules work, how can you benefit and what cautions apply?
Credit Scores and Medical Billing
"Getting sick or injured can put all sorts of burdens on a family, including unexpected medical costs. Those costs should not be compounded by overly penalizing a consumer's credit score," said CFPB Director Richard Cordray back in May.
It turns out that a lot of credit dings are related to medical billing. A Federal Reserve study found that more than half of all collections shown on credit reports involve medical claims.
Unlike other types of claims -- say a missed car loan payment or a late check to the mortgage company -- medical billing has several very odd peculiarities.
To start, it sometimes happens that consumers may be unaware that have outstanding medical bills. If you have a student loan, you know when payment is due and how much should be paid. With medical bills, the situation is not so clear. Go to a doctor and there may or may not be a deductible. There is surely a bill for services rendered, but if you have medical insurance, you likely do not have to pay the full expense on the spot.
Instead, the doctor sends a claim to the insurance company, the insurance company accepts or declines various portions of the invoice, and at some point in the far and distant future you get a bill for any outstanding balance. The bill you get may come from an unknown billing service and not the doctor you saw, thus confusing the situation further. According to the CFPB, "about 99.4 percent" of all medical debt sent to credit reporting agencies comes from collection agencies and not doctors.
In such circumstances it's hardly a surprise that a bill from an unknown creditor involving a debt of unknown size from an event which took place long, long ago might be unpaid. After all, wasn't that something the insurance company was supposed to pay? How do you know the bill is not a scam?
The other unique thing about medical debt is that, unlike the new car or vacation you chose to finance, it's often not something you choose to acquire. You get sick and must pay for medical care -- it's not something you can defer because your finances are shaky.Some people choose to take out a personal loan for medical financing so they can pay their medical bills right away.
Because medical debt and non-medical debt are treated the same for credit reporting purposes, credit scores do not reflect the iffy and strange nature of medical claims. The government says that scores which include medical debt are about 10 points lower than should be the case when credit performance is considered.
The government also found that "consumers with paid medical collections were less likely to be delinquent than other consumers with the same credit score." In other words, even if you pay medical bills in full and on time, your credit score is likely to be lower than consumers without medical debts. How much lower? Twenty points.
Add up the unjustified weight given to medical bills, and consumers can face big penalties -- enough, for example, to move someone from a comfy 720 score to 695. Result? A higher mortgage rate and maybe not enough credit heft to get loans of a certain size. FICO says that under the new standards, borrowers with unpaid medical debts should see scores rise by about 25 points.
"Thin files" are common among millions of people. For instance, more than 21 million adults live with their parents -- these individuals are unlikely to have credit records for rent or utilities.
Should people with "thin files" be regarded as high-risk borrowers? While it's true they may not have many credit accounts, it's also true that they do not have much in the way of credit debt. In fact, FHA's underwriting guidelines specifically say, "The lack of a credit history, or the borrower's decision to not use credit, may not be used as the basis for rejecting the loan application."
From this point forward, says FICO, "instead of classifying a consumer as someone who paid or didn't pay her bills in absolute terms, the various degrees of the consumer's payment history have been quantified. The end result is a score with an improved ability to assess the risk of thin files."
Translation: Under the new standards thin credit files will not be automatically seen as evidence of high risk.
Credit Scores and Cautions
While the new standards developed by FICO should raise credit scores for millions of borrowers, some issues still remain outstanding.
First, lenders use credit scores as one of many tools to qualify mortgage borrowers. Lenders can set higher or lower credit standards as they elect, meaning the benefit of higher scores with the new standards can be lost if lenders increase credit requirements.
Second, if you have a "thin file" you likely can help your situation by dipping cautiously into the credit pool. For instance, get a gasoline or department store credit card, use it, and always pay what you owe in full and on time. That will help you get past thin file concerns.