I recently looked at two loan files, one had a 650 and one had a 750, which one was actually a riskier borrower (not the one with the higher score)? How can you now easily inflate your credit score? Is the score now useless? Why the huge changes in credit scores over the last 10 years? Did everyone in America suddenly become more creditworthy????
650 vs 750 credit scores is the higher credit score actually riskier?
I recently looked at two files, one borrower had a credit score of 750 and on a second file the borrower had a credit score of 650. Which borrower is a better credit risk? The borrower with the 650 is actually a much lower risk than the borrower with a 750 score as the higher score was gamed.
Essentially the higher credit score took out multiple credit cards with and had little or no utilization, for example they would get a credit card with a 1k limit and use 10 dollars on the card, this basically shows a very low utilization. I also could see they had taken out at least one buy now pay later loan that didn’t impact their score, and I would imagine they had more that were not reported.
On the flip side the 650 score had much higher credit limits of lets say 30k also with not much utilization maybe 1k on a few cards, but they were late on a few payments 7 months ago due to an unforeseen emergency. Furthermore they had no BNPL loans and lots of credit depth. The borrower with the 650 score is considerably less risky than the 750 score and yet they are getting hugely penalized even though they are much more credit worthy.
Importance of a high credit score
As we all know, a high credit score (typically 700+) is crucial because it acts as a signal of financial reliability to lenders and directly impacts your borrowing power and costs.
It secures lower interest rates on mortgages and loans, increases approval odds for credit cards, lowers insurance premiums, and assists with renting homes. A high credit score is essential in order to get the lowest borrowing costs, insurance costs, etc… The government knows the importance of a high credit score and created an easy solution; the government made some tweaks to what is included in the makeup of the credit scores so everyone get a higher credit score! Note this has happened under both parties and is continuing under the current administration.
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Why did credit scores increase so much?
The government knows how important a credit score is so over the last 10 years they have worked diligently to artificially increase scores. Sorry to burst the bubble, credit scores have not increased due to any fundamental changes by Americans. Here are four drivers:
- Pandemic stimulus: The government printed money and handed it out like candy to American’s that could use these funds to pay down credit card debt, car debt, etc…
- Less items on credit report: here are just a few items that no longer show on your credit reports:
- Judgements: for example someone didn’t pay their rent and the property owner got a judgement, this does not show on the credit report
- Tax Liens
- Medical Debt
- Student Debt for the last 5 years
- Student loan payments: very few have paid student loans over the last 5 years, this has given a huge boost in cash flow to millions of borrowers, even today almost 7 years after the pandemic many student loans are now in forgiveness.
- Buy now pay later: these loans are not on credit reports so someone could use a BNPL loan with no impact on their credit as opposed to a credit card
As a private lender why do I care about a credit score?
Fortunately as a private lender, we aren’t bound by certain credit scores as we hold and service all of our own loans. Furthermore, our max LTV is 60% which helps offset credit risk substantially. With this information, why do I care what the score is. I look for trends in the credit score and to see if there is anything crazy. For example was there a bankruptcy, what is the riskiness of the borrower, does the credit score fit the borrower profile. For example if someone owns a 4 million dollar house free and clear they don’t have a high credit limit of 1k on a credit card, that is a huge red flag that something doesn’t add up. The score itself is useless, but the details in the credit report can provide much greater insight.
The huge real estate problem with inflated credit scores
Over the last 10 years, I’ve seen inflated credit scores that are shown in the graphs above. It seems like everyone with a cell phone bill is now a prime borrower! Unfortunately, regardless of the score, the risk profile of the borrower has not meaningfully been altered. For example, just because someone now has a 720 score that is equivalent to a 650 score several years ago. The borrower hasn’t changed, just the grade inflation of the score.
Having grade inflation where everyone is a prime borrower on paper sounds great, but what happens in the real world is a totally different story. Assume someone 5 years ago had a 650 score, due to the changes in the credit scoring model their score is now a 720. Fundamentally everything is about the same with the borrower. The government provides a 95% loan to value loan based on the assumption that they are lending to a 720 score borrower when in reality the borrower’s uninflated score is a 650.
Long and short, government backed loans with little to no money down are substantially riskier as the borrower with the 720 score is going to have the same default rate as a borrower historically had with a 650 score. With inflated credit scores, this means that all the models on defaults are grossly underestimating the risk. Remember all the conventional/ FHA government loans are sold to the private sector via mortgage bonds with explicit backing from the federal government. This means that as long as a loan meets the criteria, if it goes bad the government makes the lender whole.
Credit Scores are no longer indicative of actual risk
Unfortunately with the changes above to credit scores, they are no longer indicative of actual risk. Fannie/Freddi have not increased their minimum credit score standards to compensate for the “grade inflation” which means that riskier borrowers qualified for riskier products with lower down payments. Essentially the government by not increasing credit score requirements due to the inflation of credit scores has led to huge increases in risk.
At the end of the day this means taxpayers are on the hook for billions of dollars in losses due to grade inflation of credit scores.
What happens in a downturn with inflated credit scores?
I’ve been in the private lending business for a while and ridden through multiple real estate and market downturns. Although, the trigger of a downturn is always different, the result is about the same. When there is a downturn, a cascading effect occurs; the market falls, dampens consumer confidence, decreases consumer spending and businesses in turn cut back to accommodate the lower spending level (layoffs, fewer purchases, etc…). This ultimately leads to a rise in defaults on consumer loans including autos, credit cards, and home loans and many times can ripple through to business loans as well.
Borrowers that have equity in their commercial or residential property are considerably more likely to make a payment. In the last crisis, there were a considerable number of “strategic defaults” where the borrower could make a payment but chose not to since the house was underwater. The theory goes “why throw good money away when I can go rent or buy another house for less than what I currently owe?”. This is a simplistic explanation of what happened in the last crisis and what will happen again. The depth of how this plays out in the next crisis is the question.
What does this have to do with Fannie/Freddie the largest purchasers of residential mortgages? With 35% of mortgages originated having less than 10% down, the probability of major defaults has been amplified. It is highly likely that there will need to be a huge bailout by U.S. taxpayers to the tune of 100 billion dollars (Bloomberg) or more (this doesn’t include bailouts of FHA or VA which also makes subprime loans with down payments less than 5%!).
When low downpayment loans are compounded with a softening real estate market along with rising unemployment the real estate market is going to get interesting quickly. Due to grade inflation of credit scores, I compare this to an avalanche where on the surface everything looks calm until one minor event like a footstep cascades and an entire mountain of snow comes roaring down.
We haven’t learned our lesson on riskiness of the credit market
We are already starting to see the beginning impacts of inflated credit scores. Debt counselors across the country say their client bookings are equal to or exceed the number in 2019. Lenders catering to low- or middle-income people have taken a hit. Furthermore, nonprime borrowers monitored by FICO spent 13% more of their credit lines on average than when Covid-19 landed, while falling behind on bank card payments in the past year 28% more often.
By the government artificially increasing credit scores, we have created a huge risk to the economy that is hiding in plain sight! Furthermore, it is perplexing that we are repeating similar mistakes that led to the collapse of various banks a decade ago. GSEs (Fannie and Freddie), which we as the taxpayer are funding/guaranteeing, are the new risk in town. They have increased their subprime lending from 5% in 2010 to 35% in 2018.
Furthermore, the grade inflation of credit scores has compounded the risk to the entire mortgage market and other debt markets that eventually will be paid as we are just beginning to see. The scary part is that there is no way to fully quantify the risk to credit quality due to grade inflation other than I know it is a big number. As Warren Buffet famously said “ you never know who is swimming naked until the tide goes out” We will have to wait and see who is the most exposed when the economy turns, but I can guarantee there is a lot hiding under the water that we don’t know about yet.
Additional Reading/Resources
- https://www.lendingtree.com/home/mortgage/down-payment-help-survey/
- https://www.wsj.com/personal-finance/a-credit-score-hangover-is-hitting-americas-riskiest-borrowers-b292d08b
- https://www.experian.com/blogs/ask-experian/judgments-no-longer-included-on-credit-report/
- https://www.marketwatch.com/story/credit-scores-got-artificially-higher-during-covid-now-many-borrowers-cant-pay-their-debts-4e44136a
- https://www.fairviewlending.com/higher-credit-score-borrowers-pay-more-under-new-government-rule/
- https://www.fairviewlending.com/top-hard-money-questions-and-answers/
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Glen Weinberg personally writes these weekly real estate blogs based on his real estate experience as a lender and property owner. I’m not an armchair reporter/writer. We are an actual private lender, lending our own money. We service our own loans and own commercial and residential real estate throughout the country.
My day job is and continues to be private real estate lending/ hard money lending which enables me to have a unique perspective on the market. I don’t accept any paid sponsorships or ads on my blog to ensure accurate information. I’ve been writing this for almost 20 years and have over 30k subscribers. Please like and share my blogs on linkedin, twitter, facebook, and other social media and forward to your friends 😊. I would greatly appreciate it.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, and Florida. We are recognized in the industry as the leader in hard money lending/ Private Lending with no upfront fees or any other games. We fund our own loans and provide honest answers quickly. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all we need is our simple one page application (no upfront fees or other games). Learn how to find a reputable hard money lender and why Fairview is the best hard money lender for investors.
Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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