Why Credit Scores are False Prophets for Tenant Reliability
A credit score, according to the Fair Isaac Corporation, is calculated based on a weighted average as indicated below.
This may come as a shock to landlords. See, landlords generally look at credit scores in hopes that it will give them an easy, quantifiable way of comparing one tenant's reliability against another, without dipping into criteria that could put the landlord at risk of a fair housing suit. Unfortunately it doesn't work that way.
Credit scores are a pay to play racket. They get higher only if you borrow and pay back assorted lenders repeatedly. In the modern economy it's just shy of entrapment. The best tenant is one who doesn't engage in risky borrowing beyond their means, and is likely to have a very thin credit history. Saying that you want only tenants with high credit scores in your apartment is like saying you only want high rolling gamblers handling your stock portfolio.
Looking at that chart above, and bearing in mind that the average tenant is younger, less experienced and less wealthy than a homeowner, a large portion of the chart can be ruled out while the info that the landlord really wants is only counting towards a third of the score.
A landlord can throw out the 15% given to length of credit history. In fact, using that part may well be discriminating against the younger tenants as they simply won't have had as much time to build up a credit history. They can also ignore types of credit used, as this only improves over time - what average 25 year old with a responsible track record is going to go out and open a couple of store credit accounts, a line of credit or two, a few mortgages, some bank credit cards and a car loan? For a responsible younger tenant you'd actually want to see this portion be on the lower side. Meanwhile if you're looking at a new graduate, nearly everything could fall within the 10% "new credit" sector and therefore cause an unfair detrimental effect on the overall score.
Of course, you can't really tell what's pushing the final score up or down unless you actually read the details of the credit report. And most landlords who are going on score only do not know how to read the rest of the report - they look at one number and base their decision accordingly.
Meanwhile, let's take a look at what's making up the Payment history and Amounts owed section of the credit score - the blue and pink portions. According to FICO's website:
- Account payment information on specific types of accounts (credit cards, retail accounts, installment loans, finance company accounts, mortgage, etc.)
- Presence of adverse public records (bankruptcy, judgements, suits, liens, wage attachments, etc.), collection items, and/or delinquency (past due items)
- Severity of delinquency (how long past due)
- Amount past due on delinquent accounts or collection items
- Time since (recency of) past due items (delinquency), adverse public records (if any), or collection items (if any)
- Number of past due items on file
- Number of accounts paid as agreed
- Amount owing on accounts
- Amount owing on specific types of accounts
- Lack of a specific type of balance, in some cases
- Number of accounts with balances
- Proportion of credit lines used (proportion of balances to total credit limits on certain types of revolving accounts)
- Proportion of installment loan amounts still owing (proportion of balance to original loan amount on certain types of installment loans)
So let's break this down a bit. The entire Payment History section is comprised of things that you want to know about before you get involved in a lease. The Amounts owed section, though, is giving weight to things that may not really matter in a one year lease. In order to score highly in this section you need to have balances at about half of your credit limit on every single card you own. Owing a large amount on your student loans (as many renters do) will harm you here. So we'll say that maybe half of the "Amounts Owed" section is worthwhile, but certainly not to the point of making up 30% of your decision on whether or not one tenant is better than another.
Meanwhile, let's take a look at the things that really could affect your relationship with your tenant which could be quantifiably measured but are omitted in the FICO:
- Rent payment history. Most landlords do not report their tenants payment history unless they leave a large balance due. Most tenants will pay their rent first before anything that appears on a credit report.
- Evictions. Unless a money judgment is issued in Chicago, the eviction will not be noted on the credit report. Simple orders for possession don't make it on here, and as we uncovered in an earlier article series, money judgments are not issued most of the time.
- Utility payments. Cell phones bills will appear on the credit report, and People's Gas is usually pretty good about reporting all payments, but ComEd frequently doesn't unless the tenant is delinquent. Many tenants will pay their utilities before they make other payments on accounts that do appear on the credit report.
- Debit card usage. Younger tenants may use their debit card responsibly, thinking falsely that it builds their credit history. It doesn't. Debit card usage, like ComEd electric payments, only appears on the credit report if a person overdrafts frequently.
... and one item that could cause a big false positive...
- Authorized usage accounts. This is when an individual is listed as an "authorized user" on someone else's charge account. My mother and I had this arrangement when I was in college. I had the right to use one of her longstanding credit card accounts in case of emergency only. By the time I got out of college my name had only been on the account for 4 years but she had owned the account for far longer. My score reaped the benefits of her good payment habits.
So we've got a score that's made up of about 35% good valid data that applies to a rental situation, 30% data that's only good for curiosity's sake, and the 35% information that is going to be weak by default in an individual who is renting. Why are we using this as a means to judge tenants? Why are landlords looking for tenants with an 715+ score in a market where the average in Illinois is 695 and anyone with half a brain and a decent income is buying right now? And why are landlords so convinced that perfect credit makes a perfect tenant? After all, consider what isn't included in that score.
- Has the client ever been sued by a landlord or sued their landlord before? If a tenant has been exposed to the court system they are more likely to do so again when they encounter a problem. There is no more difficult situation for a new landlord than working with a tenant who has been burned before.
- Does the tenant have student loans that will mature during their tenancy? If an applicant's loans are currently deferred they may have very good credit, but if those loans suddenly come due in the middle of their lease they may have trouble paying all of their debts simultaneously.
- Did the tenant try their best to save their home before they had to short sell? A short sale will severely knock a tenant's credit down, but former homeowners can be the best tenants you could possibly find.
- How long did the tenant stay in their last few apartments? If they move around a lot they may bounce on you halfway through the lease.
Consider this: of the 24 tenants I've placed in apartments this year, only 3 have been subject to a full background check by their new prospective landlords, and only one of the landlord's agents even tried to call my clients' prior landlord for a reference check. 4 have required paystubs or proof of employment. The remaining 83% of the landlords' decisions were, as far as I can tell, based only on credit and a cursory read of the applications.
Also consider this: turnover costs can eat into your profits like nothing else. If your apartment sits empty for one month, you have to pay to clean & patch it, and then pay an agent's commission, you're looking at losing at least 25% of your annual income from the investment at every turnover. A tenant with solid gold credit is smart about their finances. They will know that this is a good buyer's market and how much money they could be saving by buying a place of their own. They will leave very quickly. On the other hand a tenant with weaker credit but good prioritization (e.g., rent first, everything else later) will have fewer alternatives, both in terms of buying a home and in finding other landlords willing to take a chance on them. They will stay with you longer on average.
Relying only on credit score is the lazy man's way out, and a landlord who does so gets exactly what they deserve in my opinion. When I'm working with landlords I use my own 10-point scoring system that involves far more than credit, and doesn't even require a score at all - just a list of accounts and balances like those you can obtain for free from AnnualCreditReport.com. It curves perfectly, is sufficiently quantitative, and has yet to lead me wrong after using it on over 800 rentals. If you'd like to use the 10 point score on your next rental, I'm happy to help. Contact me for more info.