The Unmysterious Credit Score

In certain circles there has always been plenty of discussion of credit reports and scores. But since the Great Recession, interest in the topic has grown to the verge of mainstream consciousness. Ordinary folks now routinely consider the credit score impact of their actions, including such esoteric issues as the undesirability of closing unused credit card accounts. (It increases the ratio of used to available credit, which is bad.)

But through all this it seems as if the underlying point of credit scores has been lost. It is not a game with arbitrary rules meant to keep consumers on their toes. Nor is it a measure of virtue.

If you are in the business of lending money, what you want to know about a potential borrower boils down to a simple question: will this person pay me back? Credit scores do nothing more than give a probability that a borrower will make good, based primarily on his history of paying other people back, but also considering such measures of financial stress as how many times he has asked for a loan recently and the credit lines to credit used ratio mentioned above.

It is easy to get lost in the details of how credit scores are calculated. (Or how we think they are calculated. The exact formulae are secret.) Geeks like me who find joy in the weird crannies of the tax code are particularly susceptible to this. But if you spend too much time trying to game the system you tend to miss the forest for the trees, forgetting the underlying purpose and logic of credit scores.

I am reminded of this by a recent post at The Consumerist that shared the apparently non-obvious tip that Letting Mortgage Go Delinquent To Qualify For Short Sale Damages Credit. In what alternate reality could skipping mortgage payments not damage your credit? For that matter, how could a short sale, in which a borrower settles a debt for less than what was owed, not damage credit?

This inexplicable confusion about the effects of not paying your mortgage as agreed has been something of a recurring theme. Back in December, when some people still thought Obama’s mortgage modification scheme would have significance, CNNMoney broke the news that mortgage modifications are bad for credit scores. This was, apparently, a shock to some of the participants in the program and even to some of those running it.

There is an emotional issue here. Homeowners with more mortgage than they can afford consider themselves to be the victims of circumstance. By and large, they did what all the personal finance advisors told them to do. And it seemed like everybody else was buying big houses with big mortgages. Then things went bad and, poof, they owe more than they can pay.

I am not entirely unsympathetic to this. Penalizing a homeowner for doing what he was “supposed” to do but at the wrong place and time is not as fair as dinging a consumer who blithely runs up credit card balances he cannot afford.

But fair is not what credit scores are about. They do not consider morality, justice, or virtue. All a potential lender wants to know about is the likelihood of being paid back, and the first indication of that is the borrower’s history of paying others back. Failing to fully repay a loan is bad. Why that happened, be it carelessness, greed, or even well meaning but naive foolishness, is relatively unimportant.

The fact of the matter is that, despite everything, the vast majority of homeowners have managed to stay current on their mortgages. Those people will have an easier time borrowing money in the future than those who did not. Which is as it should be.

At the detail level, credit scores are complex and even mysterious things. But in the big picture, they are simple. Lenders like borrowers in the habit of paying back loans. Like many things in life, if you want others to trust you, be trustworthy.

[Photo – Stopmangohome]

Credit Cards, Media, PF Blogs | Frank Curmudgeon | July 13, 2010 11:59 am

26 Comments

By BrianF, July 13, 2010 @ 4:43 pm

Amen to that!
By Investor Junkie, July 14, 2010 @ 7:38 am

I never understood why closing accounts (decreasing the amount of available credit) is a bad thing?? After all, you have less credit available to you. Wouldn’t that make you less likely to go over your spending limits and therefore less likely to default on the new lender?
By Dan, July 14, 2010 @ 10:55 am

IJ,

Two things there, and I think Frank touched on one. First, credit utilization is a fairly important statistic, and not wholly without reason.

At the high level view, who is at more of a risk: Someone who has maxed out all of their credit cards and is seeking more credit, or someone who has plenty of available credit and is seeking more? The best borrowers (ie most profitable) are those that carry some balances (and pay some interest) but not those who are close to financial destruction. That’s not to say that someone in either group could buck the trends, but by and large, this is a numbers game, and people with low utilization are generally not significant risks.

So closing an account, as Frank points out, lowers your available credit and increases your utilization.

Next, another factor is your length of credit history. I’m not as familiar with the mechanics of this one, but by and large, people with longer credit histories are better risks. (It’s been said that no credit is worse than bad credit…) Closing an old account could have the potential of lowering the average age of your accounts, and if that were to happen, you’d see a drop in score. So closing accounts *may* have an impact on your score, but it’s not a given.

As for the thought experiment you raise is concerned, credit scoring is about risk pooling, not what we think is rational behavior. And risk pooling is based on consumer behavior, and we sure as heck know that this is not rational.
By Dan, July 14, 2010 @ 11:01 am

“Then things went bad and, poof, they owe more than they can pay.”

I’m not sure how to interpret this quote and the related passage.

“Things go bad” could mean that a homeowner now owes more than the house is worth. But this in and of itself doesn’t change what the homeowner can afford to pay.

“Things go bad” could mean that a homeowner loses his job, and now can’t afford to pay his bills. Different story, and guess what? He still can’t pay. That’s why even the best credit tiers still have some risk to them. I’m not sure I have lots of sympathy for people who bought more house than they needed at the expense of an emergency fund. (Now, if you truly did everything right, ended up in a crappy economy with no job for a year, well, okay, now we’ll talk about being a victim of circumstance.)
By SophieW, October 13, 2010 @ 8:55 pm

I think the credit scoring system is highly abused! It was originally created to lenders could guage who would be the most profitable, without going bust…

As long as you stay withing the defined limits – not too much credit, but keeping a balance and therefore paying interest – you get the hightest score.

Why on earth are employers allowed to use these scores as a basis for hiring? The guy who is rolling in debt because he just went through a nasty divorce isn’t necessarily a risk to hire…

And don’t get me started on banks using credit scores as the sole basis for granting mortgages… What happened to Debt Service Ratios?

sigh…
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