The Fair Isaac Corporation (FICO) is making some changes to the formula for calculating its well-known credit score, according to the New York Times. This change may affect your FICO score, which, in turn, may affect your creditworthiness when applying for a loan of any kind. In general, these changes will make a home equity line of credit (HELOC) more attractive than a personal loan.

Overview

The purpose of the latest changes to the FICO scoring formula is to fine-tune credit scores for the benefit of lenders. Dave Shellenberger, Vice President of Product Management at FICO, says the new formula is based on trends in consumer behavior noted from FICO’s analysis of millions of credit files. While those with good credit always have benefited through higher credit scores, this change will mean that consumers with good credit will benefit to a greater degree than previously, while those with weak credit may see a further drop in their credit scores. As a result, people in financial distress may find it even more difficult to obtain loans or may have to pay a higher interest rate if approved for a loan.

The primary components of the FICO score aren’t changing, although they’ll be used slightly differently to more accurately identify signs of financial trouble. Take, for example, the increasingly common practice of consolidating credit card debt with a personal loan and subsequently running up the balance on the credit cards again. The new formula will assess a greater penalty for this type of behavior.

History

FICO changes its scoring system every few years to account for changes that it has noted in consumer behavior. The last change before 2020 was in 2014, when it had the effect of generally increasing credit scores. This time, FICO is offering two new scores, FICO 10 and FICO 10 T, that are intended to reflect the healthier economy and the fact that consumers are generally managing their credit better. Moody’s Analytics reports that late payment rates are at their lowest level since 2005. Because of these factors, credit scores have been increasing since the last change to the formula.

Nevertheless, consumer debt is still quite high, especially for Americans in the lower and middle income brackets. The new scoring system will help lenders gauge your level of risk more accurately, according to FICO. This benefit can be particularly helpful in mitigating risk for lenders if the economy slows down.

Changes

Unsecured debt such as personal loans and credit card balances will reduce credit scores under both the FICO 10 and FICO 10 T scoring systems. However, consumers with equity-based loans such as HELOCs and home-equity loans won't suffer as much because their debt is secured by equity. Some HELOCs, including Figure’s, share characteristics of both home equity loans and credit cards. Figure’s HELOC provides the borrower with the entire amount of the loan up front*. Furthermore, you can continue drawing on the line of credit after you pay off part of the amount you’ve borrowed to date.

Another change with the FICO 10 T is that it now considers two years of credit balances instead of just one month. This change provides lenders with greater insight into how consumers manage their credit over time. VantageScore is a scoring formula that’s jointly managed by the big three credit-reporting companies: Equifax, Experian and TransUnion. VantageScore incorporates FICO 10 T, which gives greater weight to missed payments and higher credit usage over long periods. FICO 10 T can thus hurt consumers who rely on credit cards during unemployment and make it more difficult for them to get back on their feet.

Effects

About 110 million consumers in the United States will experience only modest changes in their credit score, if that, from the revamped FICO scoring model. Another 40 million with favorable credit scores will gain about 20 points, while another 40 million with low credit scores will lose about 20 points. Some lenders, especially mortgage lenders, will hold off on using the new scores temporarily, while others, such as Fannie Mae and Freddie Mac, will still base their guaranteed loans on the older FICO scoring algorithms for the time being. These federally guaranteed loans account for a large percentage of mortgages issued in the U.S.

Other lenders will also continue using the previous formulas, and it isn’t clear at this point how quickly they’ll adopt the new methods. However, all of the big three credit-reporting companies will provide the new scores by the end of 2020, beginning with Equifax in the summer.

Recommendations

The new scoring systems provide even greater reason to ensure that your finances are in order before applying for a loan. When you review credit reports from the big three reporting bureaus, you'll need to take a longer look back in your records to correct mistakes, because your credit score will be based on a longer period of behavior. Bear in mind that you're entitled to review each of your credit reports once a year for free.

Financial experts have traditionally recommended that you begin improving your credit score a month or two before submitting your applications for personal loans. However, you now need to begin this process months earlier to ensure that your credit report shows a longer trend toward reduced balances.

This change makes it even more important to consider equity-based loans such as HELOCs over personal loans. Getting approved for a HELOC depends much more on the value of your home equity than on your credit rating, so it won’t be affected by the new scores nearly as much as personal loans.

Summary

Despite the tweaks that will be made to the FICO scoring algorithm in 2020, the overall importance of factors such as payment history, credit utilization and the length of your credit history hasn’t changed. Much of the traditional advice for obtaining a loan still applies, including making payments on time, applying only for credit that you actually need, and minimizing your credit card balances.

*The Figure Home Equity Line is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw. You must pledge your home as collateral, and you could lose your home if you fail to repay.