Lending standards should change with default rates
If a financial institution lowers the minimum credit score it requires for approval of loan applications (known as its score cut-off), the lender must be assuming outsized risk, right?
Actually, contrary to recent media reports, that’s not necessarily the case. In fact, the risk represented by a credit score changes over time. More specifically, consumer probability of default(PD) — the likelihood, expressed as a percentage, that a loan applicant will go 90 days or more past-due on a credit obligation in the subsequent 24 months — changes over time. PD changes as consumer behaviors change, and defaults tend to come in waves, as we saw during the Great Recession.
The chart below demonstrates how the default rates associated with VantageScore credit scores of 680 and 620 changed over time from the 2003-2005 period through 2010-2012. You can see that default rates more than doubled in the time between 2003-2005 and 2008-2010. This timeframe corresponds with the Great Recession. Additionally, PD values for other scores will have changed to varying degrees as well during the same timeframe, some more and some less.
You can also see that default rates peaked around 2008-2009, and have since decreased significantly, most recently to levels nearly as low as those seen during 2005-2007, before the recession.
This has a few important implications.
First off, if a lender approved someone with a credit score of 680 in 2005 and didn’t increase its minimum credit score for subsequent approved loan applications, then that lender would be would be susceptible to many more loan defaults, and would be assuming greater risk.
Second, the opposite is true as the recession has eased and consumer behaviors changed again. In other words, a lender that raised its minimum credit score threshold when default rates ramped up, but doesn’t lower it as default rates trend lower, could result in their credit score minimums being too stringent, relative to the risk the lender is willing to assume. Under such circumstances, if all other lender credit criteria remain unchanged, lowering score cut-offs isn’t a matter of “loosening standards,” it’s a matter of preserving them. Each lender has its own lending strategy, and wants to approve as many loan applications as it can within its strategy. Making sure they aren’t leaving good lending opportunities on the table is important to lenders. Regulators also want to see creditworthy borrowers approved.
This situation is playing out in the mortgage market. Some lenders are lowering credit score minimums. There may be a variety of business reasons for them to do so. One is that the default rates at the lower end of the credit ranges have decreased, so lenders can accept more loans with lower credit scores while retaining comfortable, even consistent, risk levels.
This topic provides a nice transition to the first article in the newsletter, which covers a new model conversion video we have posted on VantageScore.com. This video focuses on how to set optimized score cut-offs when using a new credit score model. A companion video covers loan origination trends during the recession.
Read on for more consumer-related content. Right around the corner is spring, the traditional home-buying season. We’ve included a terrific article, from credit score guru John Ulzheimer, that provides tips on preparing credit profiles for those who are in the market for a mortgage.
Our “Did You Know” article uncovers how many lenders use more than one credit score model, and this month’s featured “Five Questions With…” subject is Jim Parrott, senior fellow at the Urban Institute and former senior White House adviser on housing matters.