This article is part of Wellesley Hills Financial’s Market Movements series, found in our weekly newsletter.
Here’s A Riddle: What happens to credit scores during a global pandemic that causes mass unemployment, forces millions of Americans into loan forbearance, and increases private U.S. consumer debt by several hundred billion dollars?
Answer: Credit Scores Improve.
Credit scores were created with the intent of measuring the likelihood that an individual will make timely repayments of his or her debts. The score is based upon a confluence of factors, including payment history, amount owed, length of credit history, new credit, and credit mix. Unfortunately, just as with all data models, the output is only as valid as its inputs. Thus, it is not that the average American has emerged from the pandemic better positioned to repay their debtors, but rather, government intervention during the pandemic has rendered credit scoring models less reliable in the short run.
During the onset of the pandemic, government programs were put in place to avoid mass loan defaults – mortgage payments, student loans, and even lease payments were put on hold; however, for the purpose of credit scoring models, all deferred payments were assumed to be made on time. According to an analysis published by the New York Federal Reserve on May 19, individuals who took advantage of the COVID-19 mortgage relief programs saw credit scores increase by 14 points, while those who did not take advantage of the programs only saw 7 point increases. For those borrowers on the lower end of the credit score spectrum, the impact was more pronounced: subprime mortgagors (credit scores below 620) saw average credit scores improve by 57 points.
With the pandemic swiftly coming to a close, there are still 2.2 million homeowners deferring repayment of their mortgages. Once loan forbearance programs are terminated, the New York Federal Reserve projects that up to 3.8% of homeowners may enter severe delinquency and ultimately default on their mortgages, with credit scores declining in accordance.
The takeaway? For the next several months, credit scores, especially on the lower end of the spectrum, should not be utilized as a meaningful metric while assessing a consumer’s credit worthiness. Until the economy has stabilized, lenders are flying blind.
