The Credit Scoring Crunch

Wanting to make financial services — particularly access to credit — more inclusive is a popular goal and a tricky needle to thread.  The benefits of inclusivity are myriad, but come with a significant attached asterisk: expanding credit is only a good idea when it is expanded to the right people. Expanding credit blindly is a disaster for everyone involved.

Gone right — credit products are a tool of upward mobility. Starting a business, buying a home and securing a car fall into the big three of middle class social mobility, and all three are largely made possible through the extension of credit. Dry markets yield rough results — millennials aren’t buying homes at generationally expected rates, and new start-up business are employing 1 million fewer people in 2016 than they were in the year 2000.  Overly lax standards, on the other hand, lead to the mortgage underwriting bubble that ultimately touched off the Financial Crisis, Great Recession and credit crunch.

It’s a narrow needle to thread and one that is fundamentally important to thread correctly.

Which leads to the problem of credit scoring. The FICO score (in all of its many, many derivative forms) remains the preferred standard in underwriting decisions, largely due to the fact that it is far and away the dominant scoring standard for mortgage lending. But new research from Vantage — a FICO competitor — indicates that although the “good” bets FICO identifies are actually good bets, the model isn’t identifying enough “good bets.”  Looking over data for consumers ranked “unscorable” by FICO, a base of around 30 million customers, it becomes pretty clear that there are an awful lot of consumers excluded from FICO who are being excluded by lenders when they should actually be courted by them.

“There is a longstanding perception that if consumers are conventionally unscoreable, it is because they are too high-risk to qualify for credit, or simply don’t need it,” said Sarah Davies, VantageScore Solutions’ Senior Vice President of Analytics, Product Management and Research.

The problem with that view, according to Davies, is that it is just false.  Across a variety of metrics, thin file consumers tended to be conservative about credit and its uses — but not inherently more risky when looking at the broader swath of their money management behaviors, which are also highly trackable. These consumers also tend to be victims of their own carefulness with credit, notes Davies, because thin-file credit tends to be a self-perpetuating proposition.

“Lenders need to choose their credit scoring model carefully to ensure they can ‘see’ all creditworthy potential borrowers. Inhibiting consumers’ access to credit without seeking a holistic understanding of their creditworthiness only propagates sparse credit file conditions and conventionally unscoreable status.”

So how to compare a scored apple to an unscoreable orange?

The Holistic Approach

Vantage Score 3.0 (the most current version of the model) is a FICO competitor more focused on going broad — which means it tends to look at all credit-related activity over a multiple year period, as opposed to the more card and mainstream lending focus of the FICO.  This larger group that Vantage can survey is their expanded population — and it scoops up 30-35 million more consumers than FICO was designed to rank.

But how do those populations stack up against each other — Vantage’s expanded population vs FICO’s conventional population? That is what the latest study was tasked with discerning.

So, using Experian’s data, they compared their population to the FICO scored population across criteria like credit capacity and capability, income, employment, debt  and geographic location.

What did they find?

That these two populations weren’t all that different; when compared across income, employment level, bill-paying activities, debt management — the more similar across demographic rankings, the less significant the difference between Vantage’s expanded population and FICO’s conventional population appear.

With one very big difference: FICO’s conventional base has access to credit, Vantage’s expanded population often does not — or has rather limited access.

By The Numbers 

The problem, according to Vantage’s report, is that some consumers — particularly those with a plastic allergy — often show up in credit screenings as higher risk than they ought to. “Conservative users of credit with strong financial foundations are assessed as high risk,” the study notes, which is basically the exact opposite of the desired outcome.

Particularly, notes Vantage, because the expanded population consumers are, by all accounts, fairly stable over time. Seventy-six percent of consumers with scores above 620 at the beginning of the two-year period maintained scores above 620 through the end of that period. Seven percent of consumers with scores below 620 at the outset raised their scores above 620 by the end of the period.

And, across the board, the expanded population is similar to its conventional peers — though not identical. Vantage Score consumers on average make less than the FICOed counterparts — a little over $52K per year as opposed to around $77K. But the difference in debt they can afford to carry in a mortgage is comparable — with only a 12 percent difference capacity ($149K vs $131 K). The two consumer groups are even about the same age.

But their experiences in lending are different. Conventional households, on average, are able to get banks loans that are 33 percent larger, while expanded pool customers starting to use credit find that they’re limited to 14 percent of what conventional consumers are offered on bank issued cards.

The biggest drag, however, is and will be in mortgage underwriting. Vantage estimates that with a more open scoring model — like the one they sell, to take with the appropriate grain of salt — could add 2.5 million new buyers to the mortgage market immediately with little risk, as they are extremely similar to the 620 FICO scores that are being qualified today.

Over lending was a problem for the environment — but under lending can be just as much of a drag, albeit a less expensive one.

And if there are consumers locked out of credit markets who want it — and who are stable, well-capitalized and otherwise desirable — it seems that slipping them a key would be a more productive effort than continuing to buttress the door.