Long after the economy recovers, millions of Americans will be left with a grim legacy of the recession: damaged credit scores, the three-digit ratings that help determine consumers' ability to get loans and other types of credit.
Even though some consumers have seen their credit scores improve as they trim their debt, others have seen their scores drop significantly because of late payments on bills, foreclosures and rising credit card debt.
Meanwhile, lenders' actions during the recession are delivering another blow to borrowers — even some with pristine credit. Lenders are closing credit card accounts and lowering credit limits for millions of consumers and business owners who have never paid late. Some lenders are reporting mortgage modifications in a way that dings consumers' scores, dealing a setback to those trying to get their finances on track.
More lenders also are adopting a new scoring model the financial industry believes is better at predicting risk — but that could move consumers' scores more than 20 points up or down. The most widely used credit score, the FICO score, ranges from 300 (poor) to 850 (excellent). Consumers with scores above 750 generally qualify for the lowest-rate loans.
"The credit environment has a whole lot of moving parts that weren't there three years ago," says John Ulzheimer, president of consumer education for Credit.com. "Consumers can't just sit still and expect all is well."
From the third quarter of 2006 to the second quarter of 2009, the number of consumers considered "deep subprime" — with such low credit scores they qualify for credit only at steep interest rates, if at all — rose from 34.4 million to 39.8 million, according to research by the Experian credit bureau and Oliver Wyman, a consulting firm.
Meanwhile, the percentage of "superprime" consumers, who are able to qualify for the best rates, dipped in recent quarters, partly because more people paid their bills late, the firms found.
Lenders say they're taking steps to reduce their risk in a difficult economy. Some admit they're concerned about the impact of their actions on consumers' credit scores but say they have no control over how scores are determined.
"Banks have no motivation to take an action that will impair someone's ability to obtain credit," says Claudia Callaway, partner at Katten Muchin Rosenman, a law firm that represents lenders.
But consumer advocates say regulators and Congress need to address lender actions that are unintentionally hurting credit scores. They say that as underwriting standards tighten, even a small change in a credit score could affect what rate consumers get on a loan — if they get one at all. Some analysts also say the fact that consumers' credit scores can fall even if they've never missed a payment or exceeded their credit limits raises questions about the score's usefulness.
"All these changes are new structural changes in the financial system," says Leonard Bennett, a Newport News, Va., lawyer who has testified before Congress about credit-reporting issues. "The ability to predict risk and integrate that into a credit score — based on historic data — is logically impossible."
But Tom Quinn, a vice president at Fair Isaac, which created the FICO credit score, says its data show the scoring formula "is working," because it's able to rank consumers' riskiness.
For now, with little guidance from regulators, lenders are moving ahead with actions that could lower many consumers' credit scores and hinder their ability to get credit. Here's how:
1. Cutting credit card lines
As lenders slash credit card lines and close accounts, they're raising the percentage of available credit that consumers are using — a key factor in FICO credit scores — and making many people look riskier to lenders. By the end of 2010, lenders will eliminate $2.7 trillion of the $5 trillion in available credit on cards, analyst Meredith Whitney says.
Surprisingly, those who pay their bills on time and don't go over their limits are experiencing the bulk of lenders' reductions, industry research shows. These consumers often have a lot of unused credit. By paring back this available credit, lenders are freeing up capital they're required to hold against the loans in case consumers default.
Mary Lou Reid of Arcadia, Calif., is an unwitting symbol of the lenders' actions. Despite being a financial planner and having a perfect payment record, she's had 68% of the available credit on her credit cards eliminated over eight months.
When USA TODAY profiled Reid earlier this year, Chase had closed two of her accounts, citing inactivity. Since then, four other lenders have closed or cut limits on eight accounts. One lender also more than doubled her credit card interest rate, prompting her to close the account.
Reid says the lenders' moves have taken a toll on her credit scores.
Her FICO scores have dropped — each of the three major credit bureaus (Experian, TransUnion and Equifax) has its own FICO score — with her Experian score plunging the most, down 52 points to 722. She attributes the lower credit scores largely to lenders' credit reductions. As multiple issuers closed or reduced her credit lines, Reid says, she borrowed from an inactive card to try to prevent it from being closed.
Because of the lenders' actions, she says, she's halted the expansion of her office. She's also cut back on buying major business supplies and hiring workers at a time when the economy could benefit from a boost in consumer spending. "I'm angry that I spent years dotting my i's and crossing my t's, and this is where it has gotten me," says Reid, 62.
Chase declined to comment on Reid's situation. In a mailing earlier this year, it stated, "If we close your account or suspend your credit privileges or any feature, we will not be liable to you for any consequences." Bank spokeswoman Stephanie Jacobson says the bank is trying "to be more transparent" in such cases.
From October 2008 through April, an estimated 24 million U.S. card holders had their credit card limits reduced or accounts closed, even though they had no new "risk triggers" such as late payments in their credit reports, Fair Isaac says. Of that group, 8.5 million saw their credit scores fall.
Most consumers saw "little impact" to their FICO scores, Fair Isaac says, with a typical drop when it happened of less than 20 points. Yet a 20-point drop can be disastrous and mean paying up to $552 more a year in interest on a home equity loan, Fair Isaac and Informa Research Services data show.
Credit line reductions are particularly problematic for small businesses, says Todd McCracken, president of the National Small Business Association. A 2009 NSBA survey shows that 59% of small businesses use cards to finance their business. This survey also shows that 41% of businesses had their card limits cut from April 2008 to April 2009.
Marilyn Landis, 56, a small-business owner in Pittsburgh, says that in the past year she "hunkered down" to cut her card balances. As she did so, one issuer lowered her card limit by $5,000 — to $100 above her balance — without citing a specific reason. Then another issuer sent her a letter saying that because her credit score had dropped, it was lowering her credit limit. (She didn't check to see how much her score dropped.)
"I'm paying my balance down, and the end result is that I end up with a worse credit score and less credit availability," says Landis, whose firm analyzes businesses' balance sheets and inventory systems. "That's a lousy cause and effect."
2. New credit scoring
More than 400 lenders have begun testing or using a new version of the FICO credit score — called FICO 08 — including five of the USA's seven largest banks. The model is expected to more accurately assess consumers' riskiness, which could help lenders trim their losses. The new score emphasizes how much available credit consumers are using, says Fair Isaac, because its data show that consumers with higher usage tend to be much riskier.
But the switch comes as lenders are cutting credit lines, making it appear that consumers are using more of their credit even if they have done nothing wrong. "It's bad timing," says Bennett, a lawyer for consumers on credit issues. The new score "adds unpredictability to the financial system."
3. Loan modifications
A growing number of cash-strapped consumers are working with lenders to modify their mortgages so they can stay in their homes. But these modifications could wreck consumers' credit.
A modification is typically a change in loan terms. Usually, the interest rate is reduced temporarily to lower monthly payments. The amount of principal owed isn't changed, and no debt is forgiven.
But such arrangements can damage a credit score because of the way lenders report loan modifications to credit bureaus. Under Credit Data Industry Association rules, loan modifications are reported as "partial payments." This could result in "a serious hit to your score," Ulzheimer says. "The argument we keep getting is that if you modify your loan, it means you can't afford it," he says. "That's not true. If you modify a loan, that could be a ... decision to lower your payment."
Borrowers who have done a loan modification may not know that their score has been hurt until they're rejected for a loan or get a notice that their credit card account has been closed, he says.
Cathey and Glenn Hargrove of Tampa applied for a modification in March after Glenn, 55, lost his job as an environmental consultant. They were approved for a trial modification in May and made all their payments on time, Cathey says. But the couple say their mortgage servicer, CitiMortgage, reported to the credit bureaus that they made partial payments that were delinquent. They recently learned that their modification had been denied.
Their Equifax FICO score plummeted to 635 from 801, then returned to the high 700s after CitiMortgage corrected the record to show their payments weren't delinquent, Cathey says. Their TransUnion FICO score, however, went from 801 before the modification to 645 and hasn't budged.
Spokesman Mark Rodgers says CitiMortgage generally doesn't comment on individual situations. The government's modification program says the lender "must report" the payment so it complies with the Credit Data Industry Association, he says.
The industry should come up with another way to classify loan modifications, Cathey Hargrove says. "If we were a bad credit risk, it was going to show up before this," she says. "If you haven't seen that, do we really deserve to look like 645?"