It’s the number that bears your creditworthiness — your credit score. And for tens of millions of Americans, their credit score is about to change.
First, some background — a Credit score is crucial for anyone seeking a loan. Created and managed by FICO, credit scores attempt to put a number value on each potential borrower’s creditworthiness. To determine a credit score, FICO measures payment history, outstanding debt, length of credit history, and credit utilization. From this data, the company produces a score ranging from 300 to 850 — the higher the score, the more creditworthy the borrower.
FICO — first known as Fair, Issac, and company — was founded in 1956 by Bill Fair and Earl Issac. The company updates its methods for determining credit scores regularly. In recent years, FICO decided that an update to its methodology was needed.
Which brings us to the current moment — FICO is updating its credit scores to reflect a new trend within the lending industry — the growth of personal loans.
A Personal loan is a loan that is issued by a lender to a borrower for the borrower’s general usage. Typically, these loans have a set principal and a fixed rate of interest. This differs from credit card debt (revolving debt), where the amount of the loan and the interest accrued can vary.
The market for personal loans has grown substantially in recent years. FinTech startups like SoFi, Lending Club, Lending True, and Marcus by Goldman Sachs often advertise their loans as a means to consolidate high-interest debt.
With Americans now owing over $300 billion on their personal loans, FICO has decided that they must alter how they calculate credit scores.
FICO will alter their credit score formula; they will now categorize personal loans separately. This means that if a borrower has used a personal loan to consolidate their credit card debt, FICO will now account for that and may reduce the borrower’s credit score. As many as 40 million Americans may see their FICO score drop by as much as 20 points.
Similarly, if a borrower has taken a personal loan, but has not used it to consolidate debt, they may see their scores rise by as much as 20 points.
While FICO argues that the methodology updates are necessary, some consumer advocates are concerned. They worry that the update will push already sub-prime borrowers further down the creditworthiness ladder. They point to the fact that those with the lowest scores are likely to be the ones who see their scores fall, while borrowers with higher scores are likely to get a bump from FICO’s update. These advocates argue it’s a case of the rich getting richer.
FICO counters that the updates are necessary and that lenders demand the most accurate picture of a borrower’s ability to pay back a loan.
While the debate may not be over, one thing is for sure — the change is coming, and many consumers will see the first-hand impact of FICO’s update.