Credit Scores: What Do They Measure and Why Do They Matter to Lenders?

Banks rely heavily on credit scores (known as Beacon Scores in Canada) to assess the risk of a loan, but to most borrowers, credit scores seem meaningless and don’t reflect a farm’s ability to repay.  Beacon Scores estimate the probability that a borrower is going to miss a single payment at any time in the next six months.  For most people, it makes no sense why institutions get so hung up on this one number.    

Many farmers go their entire lives without missing a payment, yet still end up with low credit and don’t understand why. This often makes it harder to qualify for the best interest rates or sometimes get loans.  However, small changes in how you manage your credit can have a big impact on the interest you pay. First, let’s drill down into why a credit score is critical to lenders and why banks lean into it so heavily.   

Banks and credit unions protect their depositors by using shareholder capital (bank equity) to cover all loan losses. They calculate their equity by adding up their assets, which are their loans, and subtracting their liabilities, which are their deposits.  The loan values are not taken at face value, however, they are adjusted smaller by a percentage (e.g. 70%) of the principal outstanding, based on how risky those loans are, in case there are future losses. When a loan goes unpaid (default), the traditional lenders count a smaller percentage of that loan (e.g. 35%) as the asset value, which lowers their total shareholder capital. If the bank’s or credit union’s capital gets too low, the regulators fear the depositors’ money might be a risk, and regulations stop them from lending more and subsequently earning profits. This is why late payments and unpaid loans are so damaging to banks. Because of this, banks and credit unions carefully consider the risk of a borrower missing any payments before they approve a loan.   

Farmers often have low credit scores from commingling personal and business finances, and usually this is not done by choice. Unfortunately, credit score algorithms don’t take into account business credit use and very literally report only on the data without accounting for the circumstances of the individuals.   

Let's look at an example of a farmer applying for an inputs line of credit, and the lender requires a credit check, which is done on their personal credit report. To the algorithm, this looks like someone seeking more credit, which, if it happens frequently, appears to be someone desperate for money.  If this happens multiple times each year just to renew the crop input loans, the algorithm will lower the Beacon Score even though the searches are routine and normal.  Think about a typical farmer who may have in one year’s time, two credit checks for renewing input loans, three inquiries on a new truck or piece of equipment, plus the usual checks for buying a new phone or getting a new credit card. This could easily be north of ten ‘hits’ per year for the average farmer, which the algorithm will perceive to be a borrower who is constantly short of money and needs to borrow more.     

Another issue is ‘credit utilization’, which is how much of your available credit you are using. Well-managed farms plan how much credit they’ll need each year and make sure it's ready before seeding season.  As the year progresses and the crops grow, that credit often gets maxed out late in the growing season and then paid down with the money from fall sales. Credit agencies don’t consider the fact that farms earn a large part of their income in the fall. Instead, they see that the spending is far exceeding income for months on end and you are quickly running out of room to sustain this if your credit gets close to maxed out. This is known to be a sign of risk for consumers with normal monthly incomes and this will hurt your credit score.   

A third problem is accidental missed payments. Farmers have a lot of bills to pay each month, and it’s easy to miss one of the sometimes dozens of bills you need to pay. The issue is that missed payments stay on your credit report for six years. Even if you pay $50,000 a month in bills, and you missed one $75 phone bill four years ago, it could hurt your score just as much as missing a $25,000 credit card payment because you didn’t have enough cash.   

There are other issues with credit reports that farmers need to monitor, which is why it’s so important to check your credit regularly. You can do this for free through the Equifax or TransUnion websites or your online banking. The credit reporting companies are required by law to report accurate information, and they can help you fix any mistakes you find. After correcting errors, if your low credit score is still keeping you from getting the loans you need, Glengarry specializes in helping clients restructure their debts to improve their situation.  Email us JGinquiry@glengarry.ca to schedule a chat at your convenience.