One of the most important aspects of VantageScore credit scores is that they are an excellent indicator of the relative risk of default for borrowers. One of the many reasons banks and lenders increasingly rely on VantageScore credit scores is that they are so effective at rank-ordering individual borrowers. However, credit scores do not directly factor in all macroeconomic factors that may impact default rates, such as: interest rates; government stimuli; employment rates; and changes in the cost of living. By design, therefore, the relationship between VantageScore credit scores and the probability of default changes over time depending on macro-economic conditions.
CREDIT SCORE INFLATION IS MISLEADING: When people speak of credit score inflation they are implying that risk is increasing in relationship to scores; in other words, a credit score of 720 today has more risk than a credit score of 720 in the past. This thinking is flawed for two reasons:
- It is erroneous to conflate the changes in median or average scores with the relationship between scores and the risk of default.
- Inflation tends to be persistent irrespective of economic cycle with deflation being atypical. By contrast, the risk of default for a given score will decrease during stronger economic cycles and increase during weaker economic cycles.
TWO MOVING PIECES: There are two different but related factors that are important to understand: The relationship between score bands and probability of default, which tells you how the risk is changing for different scorebands; and the changes in score distribution across the population.
THE IMPACT OF ECONOMIC CYCLES: Below is a chart showing the observed probability of default by VantageScore 4.0 scorebands (with most bands being of 20-point ranges) generated for several different points in time and then tracked for the following two years for delinquencies. For September 2017, 2018 and 2019, which coincided with strong economic growth in the US, the probability of default decreased every year. For the scores generated in March of 2009 (dark blue) — when the US economy was in the midst of the Great Recession –we see that the probability of default was much higher across scorebands. As we look at the scores generated in September 2020 (orange) and tracked through 2022, we see that that the probability of default is beginning to rise, but is still lower than 2017, 2018 and 2009.
WHAT CHANGES IN SCORING DISTRIBUTION REALLY TELL US: In the same way that change in the distributions of people across income groups is not a proxy for inflation, change in the distribution of people across credit scorebands is not a proxy for increasing in risk of default. As such, changes in average or median credit scores are also not a valid proxy. Changes in the number of consumers within credit score segments and changes in risk are two very different metrics. Changes in population distribution are a good indicator of consumers’ ability to manage their finances better and are driven by many factors. One of the trends over the last decade is that with consumer’s increased access to financial education many have improved their financial habits.
WHAT HAS CHANGED WITH COVID: There have been several Covid-19 pandemic related initiatives, such as mortgage and student loan forbearance, which are scheduled to end at the end of August, coupled with swings in consumers’ disposable income that have impacted both scoring distribution and default rates. In short, the probability of default decreased across scorebands because of these forbearances. In addition, many people’s scores increased as they had more disposable income, paid off debt and saw a decrease in delinquencies. During this covid period we, therefore, observed one the biggest migrations of consumers across scorebands in recent history.
THE DANGERS OF THE “CREDIT SCORE INFLATION” MYTH: Most lenders have a good understanding that the default risk associated with any given scoreband changes over time. Nevertheless, we are coming out of a long-term era of decreasing consumer risk and there are many lenders who have not managed through a large negative turn before. Therefore, we see two big risks: not adjusting lending thresholds and/or overreacting. The result would be exposing their institutions to either a higher level of risk or shutting off credit to millions of consumers who are financially healthy. Managing risk is never easy, especially now. To help, VantageScore created its RiskRatio tools and its monthly CreditGauge analysis so that lenders can have the most timely and comprehensive information available.
CONTINUED ROBUST PERFORMANCE: During the period of forbearances, VantageScore 4.0 has continued to outperform other models, much in part due to its use of trended data which enables the model to capture information going back up to two years. This has been validated by extensive research by the FHFA (Federal Housing Finance Agency) which led to its decision to mandate the use of VantageScore 4.0 for mortgages starting next year.
WHAT IS HAPPENING NOW: Most of the Covid-19 related initiatives are either over or near ending. We are also seeing economic conditions weaken, resulting in rising default rates across scorebands. If the economy weakens further, we expect delinquencies to rise. We also expect that many of those whose scores benefited from pandemic forbearances will likely not be able to sustain their current scores. And, finally, we expect that the ending of student loan forbearance will lead to a decrease in scores and a significant increase in delinquencies for millions of impacted consumers.
IN CONCLUSION: Quod erat demonstrandum, credit score inflation is deeply flawed and the evidence points to VantageScore 4.0 continuing to perform as intended. Nevertheless, as the economy weakens, we are seeing default rates beginning to rise across financial products. Lenders should always assess how the relationship between score ranges and default rates are evolving and adapt their borrowing criteria to meet their risk thresholds.
Rikard Bandebo, EVP and Chief Product Officer
