In my recent Credit.com column, Credit Score Obsessed? Don’t Be, I likely surprised many readers by recommending that consumers pay less attention to their credit score and focus their credit management energies on their credit report. This column is likely to be more expected because I want to offer what I believe is good and beneficial about credit scoring. The benefits of a good credit score are relatively well known. Lenders and other institutions that use credit scores are more likely to offer better terms and lower-cost credit to those who have high credit scores. But other consumer benefits from credit scores aren’t as well known. In fact, credit scores have played a role in lowering the cost of credit and expediting the credit application process, to name just two of the advantages they afford consumers. In the U.S., manual credit underwriting was an incredibly arduous process before the introduction and widespread use of credit scores in the late 1970s and early 1980s. It was common to wait 30 days to find out whether you were approved for a loan—or even a credit card.
Back in those days, lenders would have hundreds—or sometimes thousands—of loan officers across the country individually evaluating credit files. These loan officers would obtain copies of applicants’ credit files and use a combination of their own judgment and corporate criteria to interpret the credit file. Their personal interpretation of consumer credit files was part of the loan decision. It is difficult to apply fair and unbiased judgment in a uniform manner under this scenario.
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About 30 years ago, use of credit scores became the norm and lenders gained the ability to expedite underwriting so that consumers could walk into a car dealership and drive out with a car. The automation provided much needed objectivity and dramatically improved efficiency.
In fact, according to a study from the Information Policy Institute referenced in a 2007 TransUnion white paper, 84 percent of automobile loans received a decision within an hour, and 23 percent of automobile loans received a decision within 10 minutes.
The era of waiting days for a loan decision is thankfully over, but that’s not to say that credit scores can or should take the place of prudent underwriting. Credit scores contribute to, but are not a substitute for, sound underwriting practices. Credit scores should be a part of any decision process for credit approval, but not the sole criterion. Credit scores provide lenders with consumers’ likelihood to pay based on previous behavior, but do not provide lenders with an indication of consumers’ ability to pay. Lenders can accomplish this by obtaining additional information such as employment status and income.
[Related Article: What's a Credit Score? Really.]
It’s not just the time savings that credit score models provide. Lenders have stressed that costs go down when credit scores are used effectively. In 2008, Jack Forestell, Senior Vice President at Capital One Financial Corporation, testified in front of the Subcommittee on Oversight and Investigations, which is part of the U.S. House of Representatives Financial Services Committee, and said, “Credit scores help us extend credit to a full range applicants, including those in underserved populations. In addition, using credit scores in conjunction with automated models makes our underwriting more efficient, which ultimately drives down the cost of credit for our customers.”
Mr. Forestell’s comment is applicable today. Right now, we’re in an environment of protracted lending—particularly in the mortgage market. With a limited number of loan applicants and originations, lenders need to broaden their lending targets without creating risk uncertainty. Here again, credit scores are part of the solution.
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According to a 2006 Brookings Institution study, between 35 and 54 million adults in the United States live outside of the credit mainstream. Many of these consumers are assumed not to have credit histories, or are considered “thin file” by other credit scoring models. There is no uniform definition of “thin file,” but many typically interpret that to mean a consumer with fewer than three accounts in one’s credit file. Using VantageScore Solutions data we’ve learned a couple of things: of the tens of millions of people who were previously considered “thin file,” 15.5% were found to fall into super-prime or prime credit bands. That means somewhere between 5.5 and 8.5 million people who may be thought to have little or no credit history, could actually have really great credit. (Vantagescore provides a score to consumers who had activity up to two years ago on at least one of the credit accounts in their file, whereas traditional credit scoring methods generally require that the activity is not older than six months.)
Two final thoughts: Credit scores, when properly applied, help match consumers with the right kind of credit. And finally, they provide an incentive for consumers to practice healthy financial decision-making…and that’s good for all of us.
This story is an Op/Ed contribution to Credit.com and does not represent the views of the company or its affiliates.
Image: Ksayer1, via Flickr