Beware of Credit Score Inflation
America's credit scores have improved along with the improving economy. Compared to 2006, there are approximately fifteen million fewer Americans with credit scores below 660 and a corresponding increase of fifteen million Americans with scores greater than 740.
That's good news, with a potential downside. Federal Reserve research suggests that we're experiencing credit score inflation, similar to grade inflation in college. The economy is doing so well that the true risk of marginal borrowers may not be properly represented. Analysts are concerned that today's consumer with a credit score of 660 – considered the boundary for subprime lending – may reflect higher risk than a consumer with a 660 credit score a decade ago.
Consumers may be doing okay now with a 660 score in a strong economy, when they are more likely to have a decent paying job – but what happens in tougher times? Are they properly prepared for an economic downturn? Are you?
Know Your Own Risk
Investors are concerned that credit score inflation plays a role in increased loan delinquencies. For example, subprime auto loan delinquencies are up 81% since 2011. According to the Federal Reserve, over seven million auto loans were at least ninety days late at the end of 2018, the highest total ever recorded. Since auto loans rely more heavily on credit scores, investors in subprime auto loan packages are worried that lenders are becoming too loose with money.
What does credit score inflation mean for you personally? With a higher credit score than you may deserve, more lenders are willing to lend you money, and in greater amounts. They are also willing to lend more money than you can realistically afford to borrow.
Your credit score may qualify you for a big mortgage or a high credit limit under current conditions. Could you make all payments if the economy tanked and your family income decreased? How would you handle an unexpected large expense like a broken-down vehicle or a medical condition?
When credit scores are inflated, you may have to be better than the lender at assessing your risk.
Keep Your Score High And In Context
A credit score is a measure of risk based on your borrowing and payment history. It doesn't take into account your assets, your income, or any future plans. It doesn't know whether you have $1 or $1 million in your retirement account or emergency fund. It doesn't know if you have three kids to put through college, if you're planning to buy a new home, or when you want to retire.
All of those situations require budgeting and long-term planning to make sound borrowing decisions. However, your budget must include contingencies for economic setbacks. It's easy to overreach for a dream home when you're stretching to get a minimum down payment and your income can barely handle running expenses.
Don't let your credit score overrule your budget – but do strive to keep your credit score as high as possible through good credit practices.
Check your credit score regularly, and your credit report periodically. Look for mistakes on your credit report and any signs of fraudulent charges or identity theft. Thieves may be racking up bills in your name and dragging down your credit score without your knowledge. Let MoneyTips protect your credit and your identity with a free trial.
Always pay all bills on time, since on-time payments make up the largest part of your credit score. Keep credit utilization – the credit you're using compared to your credit limits – below 30%. Don't close old accounts in good standing or apply for too many new lines of credit. "People get intimidated by credit and tend to overthink it," says Matt Schulz, Chief Industry Analyst at CompareCards. "It's really about doing a few specific things well over and over for many years. If you pay your bills on time every time, keep your balances low and avoid applying for too much credit too often, your credit is going to be just fine."
A high credit score is a good thing under any circumstances. It's even more important when credit scores are inflated.
Right now, the economy is solid. You may be tempted to take on more debt just because you think you can afford it – but can you really?
Sometimes, debt is necessary – for example, few people can afford to pay cash for a home or a car. However, you must keep debt modest and within a plan that takes risk into account. Set a budget that's in line with your long-term financial goals and monitor your budget regularly, making adjustments if you're falling short of your goals. Stick contingency expenses throughout your budget to account for unplanned expenses – an occasional 5%-10% of income per year is a good start.
Fully assess your risk before you take out new loans or lines of credit – don't just depend on your credit score. If you can't assess risk objectively, seek help from a qualified financial professional who can take your overall financial plans into account.
A higher credit score opens the door to more lenders and potentially lower interest rates. You'll have more options to choose from – including potentially bad ones.
You can check your credit score and read your credit report for free within minutes by joining MoneyTips.