Think credit doesn’t affect your day-to-day life?
A real estate investor with excellent credit can secure a mortgage for as low as 5-6% in today’s market. Another investor with terrible credit could pay 12-15% for the same loan, except they probably wouldn’t be offered the same loan; they would likely need to come up with a much larger cash down payment.
But change is coming to the credit reporting industry. Starting in July, the three major credit bureaus—Equifax, Experian, and TransUnion—are changing their algorithm for how credit scores are calculated.
How will credit scoring change? More importantly, what does it mean for consumers and investors?
Judgments & Tax Liens to Magically Disappear
The credit bureaus will no longer include most judgments and tax liens if they don’t include the consumer’s full name, current address, and either their Social Security Number or date of birth.
What portion of judgments and liens currently don’t include all of that data? Most of them, apparently.
Sarah Davies, Senior Vice President of Product Management and Analytics at VantageScore, explains that “almost all civil judgments will be removed from credit files, and a substantial portion of tax liens will be removed from credit files.”
Nor does the data purge end there. Information on judgments and liens will also need to have been updated within the last 90 days. Otherwise, you got it—excluded from the reports.
That means that 12 million people will see an artificial jump in their score this summer. But that kind of score manipulation and data loss come with a price tag—more on that later.
In a similar move, the bureaus will limit medical collections in credit reports moving forward.
Medical collection data will only become eligible after a six-month waiting period since there is so often confusion over who is responsible for paying them. Medical billing tends to lag and often creates enormous confusion over whether the consumer or insurer is responsible for paying a given bill.
And let’s be honest, consumers often have to dispute insurance companies’ attempts to deny reimbursements and coverage.
Trend Data & Machine Learning
The credit bureaus seem to be losing a lot of data here, which means scores with less predictive power. So how are they offsetting these losses in accuracy?
In a word, the bureaus are regaining lost ground with better data analytics.
Historically, the credit bureaus have simply taken a snapshot in time of a consumer’s data and history. With these changes, however, they are starting to look at how the consumer’s behavior has trended over the last six months. Have they shifted toward paying more bills on time? Or are their payments getting later and more sporadic? Are they paying down their credit card balances or racking up more debt with each month?
The bureaus expect their better trend analysis to improve how predictive credit scores are by over 20% for people with good credit.
But what about people with bad credit? Therein lies the rub.
Why We Can’t Just Legislate Bad Credit Away
Waving a magic wand and making someone’s judgments and liens disappear doesn’t suddenly make them a good borrower. It just means that scores are less accurate for people with previously poor credit.
Lenders price their loans based on risk. They can afford to give someone with perfect credit a very, very cheap loan, because they can accurately project an extremely low default rate. Likewise, someone with poor credit is much more likely to default, so lenders price their loans higher to account for the higher risk.
Less predictive scores mean less precise pricing, which means higher prices for anyone whose credit reports leave room for doubt.
LexisNexis Risk Solutions found that people with liens and judgments are twice as likely to default on loan payments. Those risks don’t disappear just because credit agencies change their algorithm, and lenders aren’t just going to roll over and swallow the extra risk. They’ll change their pricing accordingly.
That means higher pricing for many borrowers who previously have gotten a better deal. In other words, with more low-credit borrowers looking like mid-credit borrowers, expect higher pricing for all mid-credit borrowers. Classic subsidization.
Answer me this, while you’re at it: What is the incentive for people to pay old debts if they won’t appear on credit reports?
And what about landlords, who rely on credit reports to screen renters? Judgment data is especially significant for landlords trying to separate responsible renters from those with unpaid debts (including unpaid rent judgments from evictions).
What’s Behind These Changes, if Not Predictive Accuracy?
You already know the answer: politics.
It started in 2012 when Congress ordered a report by the Federal Trade Commission to examine credit reporting accuracy. That report found that one in five consumers had at least one error on a report with at least one credit bureau. The FTC has continually turned up the heat on the bureaus ever since.
Nor is it only the FTC. A series of lawsuits brought by state governments against the bureaus ended with settlements being reached with 31 state attorney generals. As part of the settlement, the bureaus had to remove data from their algorithm, including whether consumers paid personal bills such as gym memberships and traffic tickets.
And to bring it full circle, it was the Consumer Financial Protection Bureau that ordered the credit bureaus to remove judgment and lien data from their algorithm.
What, you thought the bureaus would intentionally leave out legitimate, predictive data? Forget about it. Predictive accuracy is the measure of success in the credit rating world. But politicians have intervened to make high-risk borrowers look artificially more credit-worthy in an attempt to make more money available for low-end consumers without having to cough it up themselves.
What It Means for Maximizing Your Score
So how do these changes affect your strategy if you’re looking for the most efficient way to improve your credit?
First, you may be off the hook, credit report-wise, for old judgments and tax liens. Regardless of its implications for credit markets as a whole, on the individual level, it means these old debts become much lower priority.
Second, it’s worth noting that the most recent version of FICO and the upcoming VantageScore updates both ignore old collection accounts that are paid off. In other words, paying them off doesn’t improve your credit score. So once again, they become lower priority bills.
Third, momentum matters. Start working on paying down your revolving debt (i.e. credit card debt) and keep paying it down every month. This is good financial sense anyway since credit card debt tends to be the most expensive debt. But even if you can only make the minimum payment one month, it’s much better than missing a payment. Build a track record of on-time payments.
Fourth, always, always pay your mortgage on time. Every month, no exceptions! Mortgage payments are now weighted heavier than other types of debts.
Lastly, when you have a medical bill due, put a note on your calendar for six months after it was first due. That’s your payment window—make sure it’s paid (whether by you or your insurance company) within that six-month window.
Better Credit Literally Means Twice as Many Deals
Better credit means smaller down payments, lower interest rates, lower monthly expenses. Get yours above 700—and preferably above 750.
Responsible Renee has a gleaming 790 credit score. Her local community bank lends to her at 6% and one point for her investment properties, at 80% LTV. For a $200,000 property with a 30-year loan, that means she puts down $40,000, pays a $2,000 loan fee, and has a monthly payment of $959.28.
Scatterbrained Steve has a sloppy 575 credit score. He’s lucky if hard money lenders will lend to him at 60% LTV. He pays 12% interest and four points. For that same $200,000 deal, his 30-year loan requires $80,000 as a down payment, an $8,000 loan fee, and a monthly payment of $1,234.34 (for a much smaller loan of $120,000).
Renee can afford to do twice as many deals as Steve. In five years, her portfolio will be twice as large and will have quadruple the cash flow because her expenses are so much lower.
What do you think about the upcoming changes? Should borrowers with good credit be subsidizing those with bad credit? How far should the government go to regulate credit scoring?
Let’s discuss below!