Common Credit Score Lending Errors

Policies and guidelines focused primarily on the avoidance of risk is one major cause contributing to the inefficient application of credit scores. Our experience in statistically reviewing hundreds of scoring models confirms lenders lose far more loan income by the misapplication of credit scores than by bankruptcies or defaults of loan payments. 

A scond major error in the misapplication of a credit score is the over reliance of staff on the score as the primary or only determinant in a credit decision.  Scores are intended to be a means of comparing an applicant to other applicants yet both paying and nonpaying applicants may have the same score. Credit scores alone are not conclusive as an independent variable in predicting the probability of repayment. 

It is our recommendation that a hybrid credit score be used to place the applicant in a level of risk defined by a range of scores and the final decision to grant or deny the loan be based on the applicant meeting the underwriting parameters for that risk level.

Considerations of Risk

All lending involves some element of risk. Within the area of non-systemic risk, three sub categories are commonly found that apply to consumer lending: 

Strategic Risk that is created by policies resulting in loss of loan income due to the lack of applicant and product diversification in the portfolio. 

Liquidity Risk based on loans to applicants that are not repaid. This risk is usually present when lenders have an unsafe concentration of loans with large balances granted to a small number of borrowers.

Operational Risk caused by misapplication of credit scores or lending practices based on outdated or inadequate processes including lack of adequate staff training.

No credit score measures contingent risk Contingent risk is the possibility that an applicant’s repayment will be negatively impacted by a loss of employment, illness, or other conditions that did not exist at the time the loan was granted. COVID is one example of contingent risk.

Defining a Credit Score Strategy

Every credit granting organization has stated goals to set a target to measure the overall performance of their lending activity. Periodic reports and analysis are used to determine the progress of the organization toward reaching its objective. Rarely does the evaluation extend to statistically reviewing how their credit scores are currently being applied.