How credit scores help prevent and recover unpaid card debt
In previous issues of The Score, we examined the credit card industry’s uses of credit scores for customer acquisition, account origination and ongoing account management. This month, we examine how the card industry uses credit scores when managing and collecting unpaid or defaulted debts.
When customers default on their debts, card issuers must offset unrecovered losses through higher interest charges and fees to all their customers. This is a normal cost of doing business, but the more that can be recovered from defaulting borrowers, the better it is for all customers.
Credit scores can play a significant role in the debt-recovery process, and they can even come into play before accounts go into default. Before an account goes into default, as part of the account management function, a drop in credit score can signal a card issuer that a customer’s credit risk is increasing. This may allow the card issuer to reach out preemptively to the customer to help him or her avoid defaulting or at least reduce the likelihood of doing so. Payment reminders, debt management plans and forbearance are all examples of programs card issuers may offer customers with declining scores in an effort to prevent defaults.
Concerning the fraction of customers who default despite all other efforts, card issuers have a choice: Assign the debt to a collector in an effort to recover it, or sell it off to a debt buyer (who may pursue the customer in a bid to recover the funds). Both options are costly for the issuer: Debt collectors are paid healthy commissions on any amounts they recover, and debt buyers typically pay pennies on the dollar for the accounts they purchase.
Here again, credit scores can help with the decision. As the issuer weighs the best way to minimize its losses, credit scores can rank order defaulted debtors based on their likelihood to make good on their defaults. Considering a defaulted customer’s ranking and the amount of his or her respective debt helps issuers determine if they want to consign the debt to a collector or just wash their hands of it and sell it off.
Credit scores may come into play yet again for debts that are sent to collections. Debt collectors often use credit scores as a way to prioritize defaulted debtors based on their likelihood of paying their obligations. This allows them to focus their time and energy on debtors who are able to make good on their obligations rather than wasting time on those who are unable or unwilling to do so.
These uses of credit scores help financial institutions address the unavoidable reality of defaulted debts and help them manage losses and remain healthy. Doing so translates to better terms for borrowers, better earnings for investors and better employment and benefits for those of us who work for them.