What is Personal Credit Score?
In the United States, there are three agencies that track and rate individuals’ financial histories to calculate a personal credit score: Equifax, Experian, and TransUnion. Personal credit scores are composed of several factors, each of which weighted differently depending on how important the credit reporting agencies deem them to be.
Each agency receives slightly different information from various reporting sources like credit card companies, mortgage loan institutions, and less obvious sources like medical billing companies and cellular phone service providers. This will have a significant impact on individual’s ability to get a personal or small business loan.
While the three credit reporting agencies are not government-owned or controlled, they are subject to a high degree of regulation to protect consumers and ensure accuracy of the information that is being reported. Under the Fair Credit Reporting Act (FCRA), individuals have the right to know how their information is being used, how accurate it is, if there is a negative consequence as a result of their credit reports, and gives the ability to seek damages against violators of the FCRA.
In general, credit scores contain five major scoring factors:
- Payment History – Making up the largest portion of personal credit scores at 35%, payment history is the most important item on the report. Potential creditors use this information to determine how likely it is that the individual will miss or skip payments if credit is granted
- Credit Utilization – This factor calculates how much credit you have available to you and makes up about 30% of individual credit scores. This is calculated by totaling the available credit an individual has on accounts like credit cards and determining how much of that total the individual is using at any given point in time
- Types of Credit Accounts – Credit agencies weight various types of accounts differently. Credit card balances (revolving debt), for example, affect scores differently than installment loans like autos and mortgages. This factor composes 15% of individual credit scores
- New Credit – 10-12% of the individual score is obtained from the number of new accounts or new inquiries for accounts an individual has on their record. Every time a new loan or credit account is applied for, an inquiry is generated to their credit record. Too many new inquiries can seriously impact a credit score negatively
- Length of History – Finally, the length of time an individual has been financially active helps the agencies calculate between 5-7% of the score. Accounts that have been open long periods of time with stable payment histories are viewed positively, while several accounts opening and closing over a small period of time can lower scores
What are the Changes?
In 2015, Equifax, TransUnion, and Experian, the three major credit reporting bureaus, formed the National Consumer Assistance Plan (NCAP). This organization’s purpose was to put in place industry-wide policy changes to help make credit reports more accurate. In July 2017, the bureaus removed most tax liens and all civil judgments from their reporting, and now they’ve gone a step further.
A recent change in the way that the three major credit reporting bureaus calculate scores could have a major impact on the scores of many people. In effect as of April 16, all tax liens have been removed from the three bureaus’ score calculations.
This means that many of the dozens of items that compose a credit score have fundamentally changed. While everyone starts at a perfect 850 score, there are many factors that can negatively impact scores, some sticking around for years after the initial action. Tax liens were once part of a trifecta of publicly-available information that showed up on credit reports: bankruptcy, civil judgments, and the liens. The presence of any one of those three could drastically change a credit score for the worse.
What are Tax Liens
Tax liens are placed on individuals by the government when those people cannot pay their taxes in full. Someone can find themselves with a tax lien for a variety of reasons, including failing to pay state, local, or business taxes. The lien documents are public, meaning they can be viewed by anyone, and can potentially impact a lender’s decision to offer a loan when used as part of a credit assessment.
In a tax lien, the government is stating that it has first rights to any assets that the individual may own to recover the tax debt owed. This indicates to potential lenders that they are looking at a risky borrower – one that is unable to repay the debts that they already have. This can mean that tax liens are grounds for immediate denial, because lenders want to be the first to receive payment on their loans and a lien places the government ahead of everyone else.
What Does This Mean For Credit Scores?
Data from the reporting agencies suggests that scores will increase 10-30 points on average, which is not an insignificant number. Some loans and products like credit cards and lines of credit are heavily score-based in their approval decisions, meaning many people that were shut out of these options before now may have several new options. This may sound like it will lead to a significant boom in the lending sector, but the data shows that only around 11% of Americans have a tax lien on their records.
These changes are big news to anyone applying for small business loans or credit cards. Lenders typically place a higher level of scrutiny on potential commercial loan clients, due to the sometimes much larger loan amounts. Anyone with a past judgment or tax lien on their credit record may have previously been disqualified nearly immediately, but this might not be the case going forward. Combined with the potential increase in credit scores, the fact that lenders will no longer be able to view potentially negative information on borrowers’ credit reports may mean an easier approval process for many applicants.
Lenders’ ability to judge an applicant’s creditworthiness will be somewhat impaired by the changes in score reporting, however, which may lead to a shift in their pricing and policies of loan products going forward. Since banks and other lenders may not have access to as much information on some of the applicants they service, the result may be that every applicant pays more to hedge the risk that banks believe they are exposed to as a result of the credit reporting shift.
Best Options for Loans
While banks and traditional lenders may find themselves needing to price their loan products higher to absorb some of the risk associated with less information on borrowers, alternative lenders, and online lenders may not be subject to the same levels of regulation and government scrutiny on their lending activities. The result may be a loan that is priced more competitively than those from a traditional lender, have more reasonable term requirements, and be able to approve with fewer restrictions overall.
Potential borrowers should enter an application process aware of their credit scores and any negative marks against them. Applying for a loan can and should be viewed much like buying any other product, with buyers assessing several options and shopping for the loan that best fits their needs and budgets.