Will Credit Score Changes Hurt You?

If you thought you understood how your credit score works, think again. The rules are changing.

According to The Wall Street Journal, Fair Isaac (NYSE: FIC), which created the popular FICO credit score, is making some adjustments to the way it calculates people's credit scores. And while some of those changes respond to criticisms that consumer groups and others have made in the past, you can be sure that the new scoring system will continue to attract opposition.

The changes
In general, the changes seem geared toward making clearer distinctions between good credit risks and bad ones. The penalties for occasional slip-ups in making timely payments will be reduced, while those who repeatedly make late payments will see their scores fall more. People who are close to their limits on credit cards will likely see their scores fall. Those who successfully manage a variety of loans -- such as having a mortgage, a car loan, and credit cards at the same time -- will get rewarded for their good behavior.

In addition, there are other specific rules that will become more important under the new system. Being more than 90 days late on a payment is already a no-no, but if you start making a habit of it, you'll see your score drop as a result. On the other hand, you might get away with single delinquent accounts if you have other loans whose payments are up-to-date. Also, simply applying for credit too many times used to lower your score, but doing so now won't cause you as much grief.

Does it make sense?
The FICO-score rule changes fit well into the context of the mortgage crisis and the ensuing credit crunch. While it initially appeared that only subprime borrowers -- the poorest credit risks -- would have a problem repaying loans, mortgage delinquency rates are now rising even among more creditworthy borrowers. In addition, credit card trusts holding receivables from customers of banks like Capital One (NYSE: COF) and retail stores like Home Depot (NYSE: HD), Circuit City (NYSE: CC), and Wal-Mart (NYSE: WMT) reported an 18% rise in defaults in October, with 90-day delinquencies up sharply as well.

It's clear that many lenders have realized that they made bad decisions in judging their customers' risk of default. Those decisions were, at least in part, probably due to reliance on FICO scores that may not have accurately assessed that risk. It's likely that FICO is merely responding with changes it believes will address the shortcomings of the old score.

For borrowers, however, the score changes could be a pain in the neck. But the jury's still out on how big an effect the changes will have. The WSJ article gives some examples in which scores move as much as 25 points in either direction, so there will certainly be some people who'll feel the pinch -- especially in the critical middle of the score range, where small changes can make a dramatic impact on borrowing rates and credit availability.

However, changes to the scoring rules were inevitable. Once borrowers figured out how to game the system by getting someone with better credit to name them as an authorized user, Fair Isaac had little choice but to eliminate that tactic as a factor in credit scores. Furthermore, new competition from a joint venture put together by the three credit rating agencies is forcing Fair Isaac to defend the supremacy of its FICO score with a lawsuit -- despite its causing particular friction with Equifax (NYSE: EFX). Some borrowers will complain, but just as the IRS acts when too many people take advantage of a tax loophole, you can't expect FICO score loopholes to stay open forever.

What to do
None of these rule changes really affects how you can get good credit. Stop yourself from overusing your credit cards, and don't let stores talk you into taking new cards for a quick discount if you won't get them paid off quickly.

If you've had good credit in the past, just keep doing what you've done and you can still expect to have a score that's good enough to keep your rates down. And while those who are trying to make up for poor credit decisions in the past may see the score change as a bump in the road, staying on track by paying down debt and making on-time loan payments is still the best way to improve your score in the long run -- no matter how they calculate it.