People who struggle to qualify for new loans because of old debts can celebrate a pair of significant victories this week.
First, FICO — the creator of the most widely used credit score in the U.S. — announced that it would no longer weigh unpaid medical debt as heavily when computing consumer credit scores. The news was followed by a proposed regulation by the Department of Education that would make it easier for students and parents who are carrying unpaid debt to qualify for federal PLUS loans.
In different ways, each of these changes would make it easier for cash-strapped consumers to access credit. It’s a reversal of the trend that took hold in the wake of the financial crisis, when banks and lenders went from handing out risky loans like candy to making it difficult for subprime borrowers to access new credit.
Improving access to credit is what many economists have argued is necessary to help jolt what has been a sluggish recovery.
But others are more cautious about loosening credit standards for certain borrowers who might end up taking on more debt than they can handle.
“If you have any money in default, whether it’s $2,000, $10,000 or $20,000, it indicates elevated credit risk, and that’s been true for decades,” says John Ulzheimer, a credit expert with Credit Sesame, a consumer credit website. “Now all of a sudden, by allowing that consumer to get more into debt, you’re not only setting up the lender for risk, but saddling a borrower with debt they [possibly] couldn’t afford.”
But, as Ulzheimer is quick to note, the argument against FICO’s decision to give people a break on medical debt collections would somehow unleash a stream of unworthy credit borrowers into the market is much harder to back up.
The problem with the current FICO score, which hasn’t been updated since 2009, is that unpaid medical debts actually aren’t a good predictor of credit risk, at least not as much as others, such as revolving credit card debt. The Consumer Financial Protection Bureau confirmed as much in a May report, which found that existing credit scoring models underestimate the creditworthiness of consumers who owe medical debt in collections by more than 20 points. Medical debt is the most common type of debt to fall into collections, accounting for more than half of all collections in the U.S., according to the Federal Reserve Board.
With FICO’s revamped algorithm, people whose only derogatory debts are unpaid medical debt could see their credit scores increase by 25 points, the company says. The higher your credit score, the better your credit card interest rate. Ulzheimer says it probably won’t be enough of a boost to make a difference between a denied credit card application and an approved one, but it would certainly help borrowers get better rates.
FICO isn’t the first score developer to treat debt collections differently. Vantage Score 3.0, which rolled out in early 2013, was the first scoring model that stopped tracking debt collection accounts that have been paid in full.
“[Unpaid medical debt] doesn’t help the lenders identify the bad borrowers from the good borrowers so there’s no sense of using it,” in credit scores, says Michael Staten, director of the Take Charge America Institute at the University of Arizona, which promotes financial literacy. “It’s not really a giveaway on the part of FICO. It’s actually a fairness issue. In some sense they’re unfairly dinging them right now.”
A bigger student debt burden?
On the other hand, the criticism of the Department of Education’s move to make it easier for indebted borrowers to qualify for expensive student loans is a bit harder to shake.
The proposed rule would make it possible for a borrower to qualify for its federal PLUS loan, which can be taken out by parents on their child’s behalf or graduate students, even if they have past due debt (less than $2,085 worth of debt 90 past due). The rule would also only dig two years into a borrower’s credit history to look for negative accounts, down from five years currently. More than 1.1 million borrowers were denied loans during the 2012-2013 school year because of unpaid debts. If the new rule is implemented, it could free up loans to more than 370,000 borrowers.
The question is whether it’s responsible to extend big loans to borrowers who’ve proven they can’t afford debt in the past. PLUS loan borrowers can take out up to the full cost of tuition and fees, whereas federal Stafford loans set limits on the amount students can borrow. And PLUS loans come with higher interest rates than the typical federal Stafford loan (6.4% vs. 4.66%).
“You’re assuming they’re going to pay [this debt] simply because it’s a student loan and I think that’s pretty shortsighted,” Ulzheimer says.
The default rate for PLUS loans has tripled since 2006, according to data released by the Department of Education in April, from 1.8% to 5.1%. But that’s still much lower than the overall average federal student loan default rate, which is 9.1%.
And federal PLUS loans are nearly always a better option than pricier private loans, which may be a last resort for borrowers who are denied federal loans. By loosening requirements for PLUS loans, the government would be preventing thousands of borrowers from turning to private lenders, whose repayment plans are less flexible than federal.
Historically Black Colleges and Universities, a group of about 100 schools, was among the most vocal supporters of the PLUS loan change. When the Department of Education first tightened credit check requirements for new PLUS borrowers in 2011, the rate of HBCU students who were approved for these loans plummeted.
For example, at Tennessee State University, the approval rate fell from 42% of students to 27%, according to the Association of Public and Land Grant Colleges, which represents 23 HBCUs. Clark Atlanta University reported that 500 students chose not to enroll after they were denied PLUS loans, resulting in $8 million in lost tuition. The APLU estimates that from 2011 to 2013 HBCUs lost more than $168 million in revenue because of the denied loans.
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