Lending in Turbulent Times
In the midst of the last Recession, dubbed, “The Great Recession,” lenders of all shapes and sizes “tightened” their credit standards. I recall much confusion about this term and why it was happening. And we spent many hours with regulators, consumer advocates and others illustrating what tight credit is and why it was occurring.
In this newsletter we’ve included a relevant and timely synopsis of a white paper illustrating the relationship between a credit score and the risk it represents. This relationship is “dynamic,” in that risk associated with credit scores change over time. The paper discusses why it’s doubly important for lenders to validate and test their models during volatile times such as these.
The way this relates to credit “tightening” and “loosening” is this: depending on what level of risk a credit score represents, lenders will adjust things like their “credit score cut-off.” This refers to the lowest credit score required for a product or particular interest rate or loan terms.
Let’s take, for example a credit score cut-off of 700. In a good economic climate, this credit score represents a fairly low likelihood of default. But, in a highly volatile economic climate with high levels of unemployment, a credit score of 700 can represent a much higher likelihood of default.
A lender usually targets an acceptable percentage of new accounts that are more likely to default, and for which they may take a loss. The lender must keep this percentage steady or risk its own financial stability. So, in order to keep the percentage or number of accounts that are expected to default steady, the lender must move its credit score cut-off higher in order to achieve the same risk level. Thus, the lender will tighten credit availability and there would potentially be fewer loan approvals but a more stable likelihood that those loans may go into default status. On the other hand, as risk is driven out of the economy, say by greater employment, the cycle reverses because as risk associated with a score diminishes, lenders will lower their score cut-offs to maintain a level risk of default.
In the current environment and in the foreseeable future, lenders will continue to monitor their portfolio of loans and move their minimum score cut-offs higher in order to maintain safe and sound credit policies. It is a balancing act for sure because lenders want to lend. It is how they remain in business!
Another area we might see “credit tightening” is in credit card limits. Lenders will also monitor their already issued portfolio of credit cards by pulling the holders’ credit scores, usually monthly. This process is known as portfolio management, which constitutes a FCRA- (Fair Credit Reporting Act) permissioned purpose for pulling a credit score. This is considered a “soft pull” and doesn’t harm your credit score.
When they do these soft pulls, they may see increased risk exposure because of a degradation of credit quality of the overall portfolio. In order to mitigate their exposure to sizable losses, credit card issuers may reduce the maximum limits for some card holders in order to limit the lender’s potential losses should those consumers not be able to pay back the amount owed. I would expect these credit limit reductions to occur over the next few months.
For card holders, a reduction in one’s credit limit can cause their credit scores to decline because it reduces the amount of credit a person has at her/his disposal, thus causing their balance-to-credit limit or “revolving utilization” ratios to increase; unless, of course, cardholders are paying down their balances in excess of the minimum payment due and using less available credit.
And I get it. You’re thinking: “Wait, my score went down and now it goes down again because my credit card issuers reduced my limits?”
There are two factors at play here. First, by reducing the amount a consumer is allowed to charge, this prevents that consumer from going into a potential debt spiral. Secondly, as economic conditions improve, consumers can ask for credit card limits to return to their previous levels, or even higher. Indeed, we did see credit loosen as the Great Recession got further and further in the rearview mirror as risk was driven out of the system.
Please read on for the aforementioned whitepaper synopsis and other educational content. And please stay safe and healthy.
CEO and President, VantageScore Solutions