Have credit scores become “watered down?”

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By now, you’re probably aware that credit scores range from about 300 to 850 (for FICO Scores), where your score sits on that spectrum, and even what’s typically considered a poor, good, or excellent score.

But what you might not realize is that the range of credit scores (and where you sit on it) isn’t as set in stone as you might anticipate. In fact, new research points to the assertion that consumer’s credit scores have been artificially inflated over the past few decades.

Furthermore, that “watering down” of credit score standards have created a precarious lending environment where riskier borrowers are getting approved for unprecedented amounts of debt every single year.

Those were the findings of research conducted by Goldman Sachs Group Inc. in partnership with Moody’s Analytics, but also backed up by the Federal Reserve.

Loose credit and underwriting standards

Essentially, they believe that the gradual loosening of credit standards as the economy grows and expands (or, becomes white-hot as we’ve seen with the real estate boom of the 2000s and our current 10-year robust recovery), results in “grade inflation.”

A good way to think of this is like when your teacher assigns a curve to your final exam in college. So, a 700-credit score today may not hold the same practical credentials and be as well-earned as a 700-credit score 10 or 20 years ago, for instance.

While there are multitudes of scoring models and even alternative scoring platforms like Vantage, FICO – the Fair Isaac Corp. – is the nation’s preeminent credit scoring product, used by over 90 percent of all lenders, banks, and retailers in the U.S. every day.

“Borrowers with low credit scores in 2019 pose a much higher relative risk,” reports Cris deRitis, the Deputy Chief Economist with Moody’s Analytics. “Because loss rates today are low and competition for high-score borrowers is fierce, lenders may be tempted to lower their credit standards without appreciating that the 660 credit-score borrower today may be relatively worse than a 660-score borrower in 2009.”

For instance, there are about 15 million additional consumers with 740+ credit scores right now than there were 740+ consumers in 2006 (and it’s not because our population has grown that much!). Additionally, we have 15 million fewer consumers with scores below 660 today than we did in 2006.

“You might have thought 700 was a good score, but now it’s just average,” adds deRitis.

What’s causing this credit scoring “grade inflation?”

When the economy is healthy and expanding, banks, lenders, and retailers scramble to accept as many new consumers as possible, extending credit to an ever-growing pool of customers. In this “Gold Rush of credit,” they inevitably start loosening their standards, discounting certain criteria, softening lending requirements, or making other adjustments to account for the fact that ostensibly, their risk is lower since people are making more money and businesses are hiring, etc.

While the big banks and lenders make only small adjustments to their credit standards, for the most part, smaller banks, lenders, and retailers often take more considerable risks in order to sign up customers and clients in an attempt to compete and thrive. We see this now with auto lenders, especially, as well as student loans, online personal lines of credit, and other rapidly-growing forms of debt.

This is also a symptom of prolonged economic recovery since the financial collapse of ’08 since the foreclosures, bankruptcies, collections, and defaults have started “falling off” or being minimized from a credit standpoint over time. So, the same consumer who had a 550 score in 2009 may be back up to 650 now, even though it’s the same person with the same spending habits and debt management.

The dangers of watered-down credit standards

Basically, the current credit scoring reality takes into account the context of our economy and the state of unemployment, household earnings, business expansion, and many other factors.

“We recognize there’s a lot more context you can obtain beyond a consumer’s credit file,” says Ethan Dornhelm, VP of Scores & Predictive Analytics at FICO. “We do not think that score inflation is the issue, but the risk layering on underwriting factors outside of credit scores, such as DTI, loan terms, and even trends in macroeconomic cycles, for example.”

But what happens when the economy stops growing so quickly, slows down, or even falls into another recessionary period? The increased risk tolerance that’s reflected in softer credit standards can (and will) come back to bite creditors in a big way. Already, we’re seeing signs of the credit and debt hull of our economy springing leaks;

The Federal Reserve Bank of New York reported in February that auto loans at least 90-days late surpassed 7 million at the end of 2018 – the highest number on record. Furthermore, the portion of 30-day delinquent auto loans extended to subprime credit borrowers has jumped by 81 percent since 2011 – in large part due to looser underwriting standards that don’t judge credit scoring as harshly.

In fact, economists say that car loans, personal online loans, and retail credit cards are most at risk when the economy slows, a bundle that accounts for $400 billion of our current consumer debt portfolio.

Add in the specter of increased interest rates on variable or adjustable rate loans, and consumer defaults may be ready to skyrocket, tipping another domino in the coming economic slowdown – although not necessarily initiated by mortgages this time.



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