Friday, August 3, 2007

Credit Scores on Prosper - Part 1 of 2

Credit scores are the most important indicator in determining what rate you will pay when you borrow money. The worse your credit score is, the more you will have to pay in interest on your loan. Your credit score is made up of a number of components including the length of your credit history, the amount of debt that you carry, recent credit inquiries by lending institutions, and the number of late payments or defaults that you have on current or prior debt. Sometimes this score is called a FICO score because it is generated with software from Fair Isaac and Company.

There are three credit reporting agencies that produce credit scores: Equifax, Experian, and TransUnion. Each of these collect information about borrowers independently and the accuracy and quantity of information on a borrower can vary among the credit agencies. Because of differences in the data collected, the score for a given borrower can also vary among these credit agencies. Some lending institutions partner with one of these credit agencies and use them as an exclusive provider of credit scores and content, while others obtain data from all of the credit agencies when making a loan decision. Prosper exclusively uses Experian while Lending Club exclusively uses TransUnion for their credit data.

According to the distribution of credit scores for the general population is heavily weighted to the higher end of the spectrum with most scores falling above 700.

Prosper uses credit grades rather than displaying the raw credit scores. The following is a chart that explains that correlation.

and up

I must say that when I came across this data I was quite surprised by this distribution. Matching the two sets of data together, we realize that E and HR borrowers combined represent only about 11% or 12% of the population (people below 520 cannot currently borrow on Prosper). Nearly half of the population falls into the AA or A credit groups.

Okay, ready for some shocking statistics? Here is the current breakdown of active loan listings on Prosper as of the writing of this listing:

Number of Listings54561132303825001308

Roughly half (49.4%) of the current loan listings are for HR borrowers, with only 2% for AA borrowers, and 2% for A borrowers. This is shocking when you consider that combined A and AA borrowers make up half of the general population while HR borrowers account for less than 10% of the general population.

One effect this has is that when lenders see an A or AA listing they think they are lending to the cream of the crop - the top 4% of borrowers. While, when lending to Bs or Cs they may be thinking, "This isn't too bad, I am still in the top 15% of loans". In terms of the number of Prosper loan listings they would be correct. However, in terms of the general population, lending to AA and A borrowers just puts you in the top half of borrowers, while Cs could put you in the bottom 25%.

This also clearly demonstrates that many borrowers are using Prosper as a lender of last resort. People who are unable to obtain credit elsewhere because of their low credit scores are flocking to Prosper in an attempt to obtain financing on their loan. Anyone with a score below 620 is considered subprime, which is the middle of the D credit grades on Prosper. With scores below that, many of the Es and most of the HRs would find it difficult to obtain a loan at any rate from traditional financial institutions.

The distribution of loan requests on Prosper suggests that Prosper is having difficulty attracting mainstream borrowers in the higher credit grades. This makes it difficult for lenders that want to lend large sums of money to borrowers in the top credit grades. These lenders are forced to spread the money out over a long time period, or aggressively bid down the rates on the small number of loan requests in the high credit grades. (See my previous article for why someone with good credit would want to borrow from Prosper.)

This is part 1 of a 2 part article about credit grades. Watch for an upcoming post in which I will describe how you can obtain a free credit report, dispute inaccuracies on your report, and monitor your credit. In part 2 I will also discuss how much it can cost you to have a poor credit score.

Edit/Clarification: In this post I compared FICO scores in the top graph to Experian's ScoreX scores used by Prosper. FICO scores run from 300-850 while ScoreX are from 330-830. There is really no one in the 830-850 range anyway, so trimming that doesn't really have an effect (same onthe bottom end of the scale). Although Experian's ScoreX scores are mathmatically scaled to match FICO scores they are produced by a different algorithm and could result in slightly different data. The overall analysis in this post should hold but the percentages may vary. Here's a short explaination from Wikipedia on the difference betwen FICO scores and Experian's ScoreX score:

For easy use, most scores are mathematically scaled so that they fall in the general range used by prominent scoring model competitors. Since the Fair Isaac Corp. provides the dominant scoring method, non-Fair Isaac method-generated scores often mimic FICO scores, (they often are derisively called "FAKO" scores).[1] Although not as widely used, these scores (e.g. TransUnion's "TransRisk", Experian's "ScoreX", and "PLUS" scores), are less expensive for borrowers to buy than is the FICO score. The business cost savings of buying and using non-FICO scores is financially tempting to some banks and credit card companies to use, as they need accurate risk assessment of millions of accounts.

Update: Part 2 of this article, which covers free credit reports, claim disputes and the importance of good credit is here.


Anonymous said...

I would just add that on Lending Club they break it down into 7 credit categories - A, B, C, D, E, F and G. These letters refer to the credit grades assigned to borrowers based on their credit scores. “A” loans are from borrowers with the highest credit scores. On Lending Club you can only borrow if you have a score of 640.

Based on information in their help section it appears that credit grades are assigned based on the following credit scores:

A - 714+
B - 679-713
C - 660-678
D - 640-659

It's unclear what the credit scores are for E, F and G borrowers but they "can only be assigned to a loan as a result of a risk modifier." Risk modifiers include debt to income ratio (DTI) and the loan amount.

Anonymous said...

FICO and ScoreX from Experian are two entirely different formula's.

The analysis here is bunk.

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