New threats to credit scores

By Liz Pulliam Weston

A long-delayed update to the leading credit scoring formula is rolling out in 2009, offering a few advantages to consumers -- and some serious new risks.

FICO 08, the latest version of the FICO scoring model, was initially supposed to be introduced in the fall but was delayed by lawsuits between its creator, Fair Isaac, and the nation's three main credit bureaus.

Everybody's since made up, and TransUnion will offer the new score to lenders starting in late January, with Equifax introducing it in the spring, said Craig Watts, a Fair Isaac spokesman. (Experian, the third bureau, hasn't yet announced when it will offer the score.)

Fair Isaac says the new score will do a better job of predicting defaults than the classic FICO, which is used in more than 75% of mortgage lending decisions and by 90% of the largest U.S. lenders.

But FICO 08 is even more sensitive than the classic FICO to how much of your available credit you're using. If your credit card issuer slashes your credit limit -- which is increasingly likely these days -- you could see your scores plunge, regardless of whether you carry a balance.

Another hazard: The new scoring formula responds more negatively if consumers have few open, active accounts. Because more credit card issuers are shutting down unused and unprofitable accounts, that boosts the chances of damage to your scores.

3 victories for consumers

Not all the news is bad. FICO 08 offers some definite improvements for consumers in several areas, including:

• Collections. The new formula ignores small collection accounts in which the original debt was less than $100. This is a big victory for consumers and one I've advocated for years, because niggling little debts -- created by unpaid library fines, forgotten parking tickets or a small medical bill that slipped through the insurance cracks -- had an outsize impact on people's scores.

• Credit missteps. Fair Isaac says the new version is less punishing to those who have had a serious credit setback, such as a charge-off or a repossession, as long as their other active credit accounts are all in good standing.

• Authorized users. Fair Isaac initially said FICO 08 would combat potential fraud by ignoring any "authorized-user" accounts in a borrower's credit report. After a big consumer outcry and potential credit fairness issues, Fair Isaac backed off and decided some authorized-user information would be included.

Adding a spouse or child to your credit card as an authorized user has long been a good way to improve that person's credit score, because your good history with the account typically could be imported to the relative's credit file. But in 2007, credit repair companies began abusing this feature by "renting" authorized-user slots from good credit risks and selling them to strangers who wanted to boost their scores. Some of these strangers bought slots on dozens of different people's cards, boosting their scores by tens or even hundreds of points.

Lenders pressured Fair Isaac to drop authorized-user information from its calculations. But consumer advocates protested, noting that the change could punish millions of innocent parties, including spouses whose entire credit history depended on authorized-user information. Legal experts also warned that ignoring information regarding spouses on authorized credit lines could be a violation of the Equal Credit Opportunity Act.

• Video: New credit card safeguards

So now Fair Isaac says the FICO 08 formula will factor in authorized-user accounts "while materially reducing potential impacts to the score," according to the company's FICO 08 marketing brochure. Fair Isaac won't disclose exactly how it does that, but speculation is that the new score will count a limited number of authorized-user accounts and ignore the rest.

Better? Worse?

Fair Isaac made another course change regarding how FICO 08 would handle "inquiries," or applications for credit. At first, the company said applying for new credit would hurt less than in the past, since initial research seemed to show that inquiries had become less predictive of future defaults. Subsequent research, though, contradicted that finding, said Watts, the company spokesman. So you still want to be cautious and apply for credit only when necessary.

But clearly, one of the biggest hazards for consumers is the credit utilization issue. As issuers slash credit limits, the gap narrows between customers' balances and their limits, which is generally bad for their credit scores.

How bad is tough to predict. A limit reduction on a single account won't necessarily trash your credit, Watts said. Because FICO scores assess a lot of data, the effect of a single factor like a credit limit reduction will depend on what other data is on the credit report and how much the line is reduced.

"The person's score could be unchanged; it could go down," Watts said. "Or in some cases, it could go up."

Continued: More ways to protect your scores

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