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Lenders tightening credit standards for borrowing

Tighten credit standards

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Credit Sesame discusses why lenders are tightening credit standards for borrowing in the second quarter of 2023.

The number of new credit accounts opened has reached its lowest level since the height of the pandemic shutdowns in the spring of 2020. According to the February 2023 VantageScore CreditGauge report, the fall-off in new credit activity reflects a more cautious approach on the part of lenders.

When lenders become more cautious, they tighten credit standards. For consumers, this means credit is likely to be tougher to get and more expensive in the months ahead. Anyone planning on applying for credit, whether a mortgage, any other type of loan or a new credit card, should take note.

Recent trends in new credit

The VantageScore CreditGauge report is significant because VantageScore is a joint venture of the three major credit reporting bureaus: Equifax, Experian and TransUnion. Their information is used by thousands of lenders, and VantageScore estimates they have credit data on 94% of the adult U.S. population.

The VantageScore CreditGauge report gathers information from consumers and lenders, and in turn provides information that lenders use to guide their decisions. This includes things like credit score trends, types of new credit activity and delinquency rates.

One of the things the report tracks is new account activity. The number of new loans and credit card accounts being opened indicates how readily available credit is. The recent trend points to significantly less new account activity.

The percentage of consumers opening new credit accounts has fallen for four of the past five months. At 5.6%, this new account activity rate is lower than the peak of 7.7% reached in December of 2021.

The slowdown has affected most types of credit. New mortgage, credit card and personal loan accounts all declined in February. Only auto loans held steady.

What lenders are seeing

Credit scores alone do not explain why lenders are becoming more cautious. In fact, the average VantageScore for U.S. consumers has risen in each of the last two months.

As important as credit scores are, they don’t tell the whole story. Credit scores are largely backward-looking. Much of the information that goes into them is based on past behavior like payment history and when accounts opened and closed.

While the track record of how consumers use credit is significant, lenders also have to look ahead and anticipate emerging trends. For example, one thing the CreditGauge report measures is the percentage of consumer accounts that are delinquent. That means that payments are overdue.

The percentage of consumer credit accounts that are between 30 and 59 days overdue has risen steadily since May of 2021. It has more than doubled in that time. While it’s by no means at a record level, it’s safe to say that lenders don’t like where it’s heading.

Seeing more consumers fall behind on their payments is especially troubling given that the amount of consumer debt is at an all-time high, according to the Federal Reserve Bank of New York. On top of that, sharply-rising interest rates have made debt much more expensive.

Credit and economic cycles

Rising delinquency levels, record debt levels and higher interest rates are worrying enough. On top of those conditions, another thing that may be making lenders more cautious is the threat of a recession.

Financial institutions are happy to lend money when the economy is growing. People spend more and generally do not have trouble making their payments.

When the economy turns sour and unemployment rises more consumers cannot pay their bills. Lenders start losing money on some of their loans and credit cards. This makes them pickier about who they risk lending money to.

As of the fourth quarter of 2022, the U.S. economy was still growing. However growth was slow last year, and rising interest rates are a stiffening headwind for the economy. Looking ahead to the possibility of tougher times may be making lenders more risk-averse.

Impact of bank failures

Another factor that might impact lending behavior is the recent failure of two banks and concern that similar difficulties might strike other banks.

In large part, those failures were brought about by a mismatch between the value of deposits and the value of loans and investments made by those banks. Banks function by using customer deposits to make profitable loans and investments.

However, a bank’s profit margin dries up if more loans go bad. Recent bank failures may prompt more banks to take a critical look at their loan portfolios’ riskiness. The outcome may be to approve fewer risky loans and credit card accounts.

What tighter credit standards mean to consumers

When lenders become more cautious, people who previously may have qualified for credit are now turned down. It also means that consumers with less than excellent credit will be charged higher interest rates to cover the risk.

Tighter credit standards could mean it takes higher credit scores to qualify for credit and to get the best credit terms. Other standards that could be affected include loan-to-value ratios and debt-to-income ratios. More cautious lenders would likely demand lower, less risky ratios in both cases.

Who is likely to be most affected

Rising interest rates have already impacted new credit users in general. However, people with excellent credit, such as FICO scores in the high 700s or better, may not be impacted much by tightening credit standards.

Borrowers a notch below that, say in the 670 to 780 credit score range, are still likely to qualify for credit easily. However, the extra interest they pay may increase compared to the customers with the best credit.

People with borderline credit are the most likely to be affected. These are so-called near-prime customers, including those with credit scores of around 600 to 670. Tighter credit standards may make the difference between qualifying and not qualifying for credit for these customers.

While not being able to qualify for credit may cause some hardships, it may not be such a bad thing in some cases. The same things that are making lenders more cautious should also make potential borrowers think twice.

If higher interest rates and a dodgy economy make it harder for consumers to afford credit, this may be a good time to slow down borrowing plans. Putting off borrowing long enough to improve their credit scores might be healthy for many consumers.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

Richard Barrington
Financial analyst for Credit Sesame, Richard Barrington earned his Chartered Financial Analyst designation and worked for over thirty years in the financial industry. He graduated from St. John Fisher College and joined Manning & Napier Advisors. He worked his way up to become head of marketing and client service, an owner of the firm and a member of its governing executive committee. He left the investment business in 2006 to become a financial analyst and commentator with a focus on the impact of the economy on personal finances. In that role he has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications.

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