More Americans are seeing their credit score slip to its lowest level ever, according to a new report released this week by credit-scoring firm Fair Isaac Corp. (NYSE: FICO). That means it's going to get a lot tougher for U.S. consumers to borrow money – especially given that banks are becoming more and more reluctant to lend.
"It's hard to see the good news in this report, unless you are speaking for the payday lenders, title lenders, and pawn stores," said John Ulzheimer, president of consumer education at Credit.com.
The FICO report shows that 25.5% of consumers – or nearly 43.4 million people – have a credit score below 600, putting them in the subprime realm. That makes them a high risk for lenders and means they'll have a tough time getting a credit card, mortgage or auto loan under stricter lending standards.
Another 9.5% of consumers have "fair" credit scores in the 600-649 range, which is still considered subprime. With "fair" scores, they're likely to need to seek loans, but may not be able to find one.
"More consumers falling into the lower part of the score distribution means that fewer consumers will qualify for new credit, [and] those that do qualify will likely not receive the best interest rates," said FICO spokesperson Rachel Bell.
Consumers are used to having a "Plan B" – an alternate strategy or personal escape plan intended as a means of compensating for over-borrowing or excessive spending. But since the financial crisis hit household income and asset value, credit card balances are way up and "Plan B" is long gone. Using the family home as a virtual ATM machine – and borrowing against the home equity – is no longer the option it was before.
"Now, there is no safety net," Ulzheimer said.
The measures consumers are taking now to remain afloat financially will carry a big cost later. When households begin to recover, they may want or need to borrow again, but tarnished credit scores will drastically limit their options – even excluding them from the credit markets.
Credit scores are calculated by taking into account payment history, how much is owed, length of credit history, and types of credit extended. Reasons for slipping credit scores – late payments, high amount borrowed, newly extended loans – can be listed on a credit report for years depending on severity, affecting the borrower even if they have improved their financial standing.
"The reason why consumers have scores this low isn't because of a little bit of credit card debt you can write a check and erase," Ulzheimer said. "These are caused by negative information, which stays on a credit report for seven to ten years. This is not something that's going to go away in a year."
The damage is likely not over. It can take months for financial blunders to show up on a credit report. And with unemployment and foreclosures so high, many unfortunate consumers are still waiting for the credit-score storm to hit home.
Ulzheimer said lenders are beginning to make loans again, but are starting at the top, with the strongest-credit-score group and will eventually work their way down – meaning those with "fair" scores could end up waiting a long time for access to the borrowing markets.
While credit scores don't tell the whole picture, they are still a highly valued part of the lending process – maybe even overvalued now, according to some experts.
"The pendulum has swung too far," Ritch Workman, a Florida mortgage broker, told CNBC. "We absolutely swung way too far in the liberal lending, but did we have to swing so far back the other way?"
The new financial reform measures include a consumer-friendly clause allowing for a free credit score check after a would-be borrower is denied a loan or favorable rate due to their score. The goal is to make consumers more financially aware of where they are, where they need to be and how to get there.
That brings us to next week's Money Morning Question of the Week: Have you been monitoring your credit score? With loans now tougher to get, how are you changing your finances? Do you have a healthy credit score, or have you done some credit score damage you'll need to repair? What moves are you making, or how are you restructuring your personal or household finances since the financial meltdown? How important do you think it is to have a healthy credit score?
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