Why It's Safe for Lenders to Lower Credit Score Minimums

Wells Fargo (WFC) and other mortgage lenders have recently begun reducing credit score cutoffs in an effort to provide greater access to credit for their customers and to take advantage of pent-up demand in the mortgage market. Critics have argued that these moves herald a return to the risky subprime lending that led to the mortgage crisis. But in an environment in which default risk is small, assuming all other underwriting criteria are met, lenders can safely shift credit score cutoffs downwards from the high levels reached during the housing crisis and its immediate aftermath.

Mortgage defaults today are very low. The mortgage delinquency rate—the percentage of borrowers who are behind on their mortgage payments by 60 days or more—fell to 3.61% in the first quarter of 2014, declining for the ninth consecutive period, according to TransUnion. Nonprime lending is also comparatively low. Borrowers with credit scores below 700 accounted for 7.21% of new mortgage originations at the end of 2013, according to TransUnion—an increase from 4.98% during the same period in 2012, but "well below" the 15.97% level in the fourth quarter of 2007. In other words, minimum credit scores have not declined in conjunction with default risk. 

The mathematics behind the argument for lowering credit score minimums is actually relatively straightforward, if you can get past one common misconception about credit scores. A given credit score is not a static representation of a consumer’s risk profile. It is a snapshot of the consumer’s risk profile at the time the score is obtained. But the relationship between a credit score and a borrower's risk profile changes over time. What lies beneath any given credit score is its “probability of default,” or PD. As economic conditions change, so do credit behaviors, and as a result PD shifts as well.

For example, people with credit scores within the range of 591 – 610 exhibited a PD of 4% in 2005, according to VantageScore Solutions. In 2010, the PD for the same score range increased by nearly 100%, to approximately 8%. The latter time period coincides with the housing market’s collapse and the ensuing recessionary environment. PD shifts of varying magnitude are seen across all credit-score segments for the same time period.

To put this into perspective, a mortgage lender using a strategy that set acceptable loans to a PD limit of 4.5% in 2005 would have set a score cutoff of 600. By 2010, the same score cutoff of 600 would have represented a PD of 8.5%--an unacceptable risk. By then, a lender wishing to uphold its lending standard of a 4.5% PD would have needed to raise its credit-score cutoff to 660.

That's exactly what most lenders did in the wake of the recession. However, unlike their peers in the credit card and auto finance industries, most mortgage lenders have not reduced credit score cutoffs in conjunction with post-recession declines in default rates. This is one reason credit remains tight for mortgage applications, as credit scores remain the principal gateway for entering the credit space.

Reducing credit score cutoffs for mortgages may not be the solution to all the housing industry's woes. But the impact would be meaningful, according to a September 2013 paper by Jim Parrott, a senior fellow at the Urban Institute and former senior adviser to the National Economic Council, and Mark Zandi, chief economist of Moody’s Analytics.

In "Opening the Credit Box," Parrott and Zandi present the economic case for trending lower down the credit score scale. Based on their calculations, if the credit score cutoff “declined 50 points, putting it back to where it was before the housing bubble, the pool of potential mortgage borrowers would increase by 12.5% or more than 12.5 million households. Even if only half of these potential borrowers were to become homeowners, the impact would be significant.”

Ultimately, lenders, services, investors and the government-backed agencies that control much of the mortgage underwriting must decide for themselves what risk levels are right for their businesses. This makes it all the more critical that market participants recognize the elasticity of credit scores.

By the same token, market observers must recognize that changes in credit score minimums, whether upward or downward, do not necessarily reflect a desire to increase or decrease risk exposure. Rather, they often stem from the desire to maintain consistent risk exposure.

This approach allows the credit box to ebb and flow according to risk, allowing greater access to credit for consumers in the short term and more effective risk management for lenders in the longer term.

Barrett Burns is president and chief executive of VantageScore Solutions, an independently managed joint venture of the three national credit reporting companies, Equifax, Experian and TransUnion, and the company behind the VantageScore consumer credit scoring model.