Monday, July 26, 2010

Paying off your mortgage will lower your credit score

A while back I was researching what happens when you pay off your mortgage. One of the things I stumbled on was this helpful blog in which the author shares his experience that his FICO credit score went down based on paying off his mortgage:

I’m no FICO credit score expert, but my understanding is that the decrease occurred because I no longer have any installment loans. Apparently their algorithms aren’t smart enough to distinguish between people who’ve never had an installment loan and people who’ve had one, never made a late payment, and paid it off within the past month.

Is it that their algorithms aren't smart enough or are they working as designed? Dave Ramsey calls the FICO credit score two things:
The I Love Debt Score

The "I've been kissing the bank's butt on a regular basis" score

That's right, its probably working as designed. Someone who pays off their mortgage isn't as good as someone who will pay interest on debt consistently to a bank. Its common sense and business wise for the bank. But how should consumers react?

I am writing this quick blog because I think people should know about this and be outraged. We should be outraged because your credit score is being used for other things while the algorithm is written for the bank's customer evaluation purposes. That is the most outrageous part of this. Insurance companies and (reportedly) some employers will look at it to determine the risk of an individual. The good news is that some insurance agencies don't use the raw credit score. From my insurance company's website on "insurance scoring":

How does an insurance score differ from a financial credit score?
When evaluating a person’s credit information to determine an insurance score, an insurer only considers those items from credit reports that are relevant to insurance loss potential. Both an insurance score and a credit score are derived from the same thing: a credit report; but they are distinctly different.

The main difference between an insurance score and a credit score is that insurance scores do not take into account a consumer’s income. Unlike a mortgage company, an insurance company is not assessing a customer’s credit-worthiness and therefore doesn’t consider income. Instead, an insurance company only considers those items on a credit report that will indicate future loss potential.

We recognize that people sometimes face difficult circumstances in their lives such as job loss, medical bills or divorce. When we consider an applicant’s insurance score, an isolated instance of a late payment will not have a significant impact on your eligibility. We are looking at long-term patterns and overall responsible use of credit.

Similarly, applicants who use cash for purchases or who don’t have established credit will not be scored negatively.

We should demand anyone aside from banks never use the credit score. If they use the credit report, so be it. But Should paying off your house make you more risky to insurance companies or employers? No! The only reason paying off you house makes you more risky is that you can, to a certain extent, do more of what you please. ;-)

1 comment:

Jen said...

Thanks for all your helpful information !

Jennifer Mumford