Between now and 2020, you will likely encounter statistics and headlines pointing out that the top range of the average American credit score has recently risen. There is a reason for this. It is because the poor credit events of the Great Depression are starting to roll off the credit reports of American consumers.
For the first time since 2005, the average credit score of an individual in the United States has hit the 700 mark. As a general FICO reference point, credit scores are viewed as follows: 580 or below and you’re considered high risk, 580-670 and you’re in that range where you’ll get a mix of approvals and rejections and likely carry a moderately higher than average interest rate, 670-740 and you have good credit such that you’ll only get rejected if you attempt to borrow a very high number relative to your income, 740-800 and you’re going to get a significant amount of unsolicited bids asking you to borrow money and you will be able to borrow on great terms, and anything above 800 is a best-in-class borrower.
Over the past twenty years, the average American borrower sported an average credit score of 678. The fact that the average borrower now has a credit score of 700 sounds like a significant improvement. The caveat is that we are nearing a point where credit scores no longer incorporate a recession.
Although it varies by state, the average credit report only takes into account foreclosures for seven years. Typically, the calculation is performed from the date at which you missed your first payment that accelerated the foreclosure. That means if you stopped making your house payments in 2009, you would no longer have your credit adversely affected in 2016. Other states do not start the clock until the foreclosure process is adjudicated in court or is sold at the courthouse steps in states that permit non-judicial foreclosure. For those individuals, 2017 marks the year of the beginnings.
If bankruptcy is the ding in your credit score, then the average wait time is 7 to 10 years depending on whether you filed a Chapter 7 or a Chapter 13 bankruptcy (Chapter 7 auctions off your stuff but discharges most of your debts, while Chapter 13 lets you keep a lot of your stuff and agree to a monthly repayment plan for five years or so that allows the creditors to get something while you get relief in the form of lower monthly payments and a diminished overall debt burden.)
The first of the roll-offs began last year and will continue through 2020 or so, so the range of typical credit scores may very well hit the 715-725 mark in the next few years.
What are the effects of living in a world in which credit scores no longer capture a period that includes a recession?
First, from the investor’s perspective, it will be difficult to analyze the balance sheets of those entities that extend credit. If you own stock in Synchrony Financial, American Express, Discover Financial, JP Morgan, Citigroup, Bank of America, or Wells Fargo, you are going to encounter a lot of headlines in the next couple of years that will tout de-risking and point to data that indicates higher-quality borrowers on the books.
That conclusion will be unwarranted because it will likely be the same caliber of borrower, but the period of analysis will only cover their behavior during ordinary economic conditions and will not include whether they made their payments during unfavorable economic times.
Secondly, for the consumer, it will be another test to see whether they have learned about belt-tightening after the last financial crisis and resolved themselves to make better decisions this time around. I am not yet aware of reasons to be optimistic that this is the case, and in fact, there are opposite indicates that indicate the same story is going to repeat itself over again because home re-financings that use the cash-out option (i.e. use their homes as an ATM) is now at a cyclical high per recent reports.
Sometimes, it is in the best interest of a consumer to pull cash out of a home. If they have a 1980s kitchen and they pull out money to remodel it, studies show that they will recapture about 75% of their total expenditure in terms of a higher home value and they will live in a property that brings higher enjoyment.
Even the perennial depreciating asset purchase—a vehicle—can be justified as an expense if someone has an unreliable car and uses the funds from their home to buy something that runs and doesn’t come with $2,000+ car maintenance bills each year.
Of course, if the money is used to remodel some aspect of the home that has a poor payoff in terms of improving the value of the home or the money is used to purchase a luxury vehicle, then the usual hand-wringing from economists that accompanies news of higher cash-out refinancings may be warranted. Particularly if the demographic of consumers making these decisions is the same class that struggled with finances during the great depression.
So far, my reaction that the average American has seen their credit score cross the 700 mark could be characterized as “muted optimism.” The optimism aspect is that I’m happy for responsible borrowers who are able to access funds and pay a lower charge on their obligations so that they can keep more of their disposable income for themselves and spend less of their waking hours enriching the shareholders of America’s lending institutions.
The “muted” aspect of my response is that there is no aspect of this recent data set that supports the conclusory notion that Americans are handling their debt obligations better. In fact, the higher credit score is merely a function of the limitations in the credit gathering process. Because credit bureaus are obligated to only capture a narrow window of time because Congress has mandated that people be given a better chance and an opportunity to rehabilitate, the average credit score only captures an economic period that is devoid of a statistical recession.
I am glad that the credit card laws are structured to permit second chances—after all, a ten-year black mark on your credit report may encompass a fifth of your adult life which ought to be punishment enough—but I also find it useful to acknowledge when the data sets have limitations, even if those limitations are the result of salutary aims.
For investors in financial companies, you should not jump for joy when you see your bank report that the credit quality of borrowers has improved. It reminds me of Warren Buffett’s admonition to focus on economic rather than accounting reality. The economic reality hasn’t necessarily changed, but the accounting has. Show me an average credit score of 700 during the next recession and I will conclude that Americans have become more responsible.
For people who are the beneficiaries of higher credit scores as foreclosures and bankruptcies roll off, now is a great time to take advantage of your reputation by lowering your cost of capital and improving the necessaries of your life. However, it is not a time for indulgences. If you can’t pay for a luxury vacation or accoutrement in cash, you should delay gratification until you are able to do so.
I say this not only as a form of moralizing, but as an exhortation of your best interest. I know a check-out clerk at Kroger who often tells me about how terrible it is to pay off the debt from her honeymoon over a decade ago. It is because she borrowed $18,000 at 16% interest to do so and has had to refinance it several times. I don’t have enough data nor the inclination to know the detailed math, but it is a good chance that her honeymoon will end up costing her over $50,000. That is an extreme example outside the range of the typical American experience with credit cards, but high interest debt is the single greatest guarantor that you won’t be able to improve your financial situation with each paycheck so an abundance of caution is warranted.