QUESTION TEXT: One of the things lenders do in…
QUESTION TYPE: Paradox
PARADOX: Usually, higher credit scores mean borrowers are less likely to default on a loan. Yet, those with the very highest credit score have the highest odds of defaulting once given a loan.
ANALYSIS: Correlations generally hold true, but there can always be exceptions. To explain this, we need some factor that makes high scorers different.
So, to be right, the answer has to tell us something about those with high credit scores specifically.
What does the right answer mean?
The right answer may be a bit subtle, so I’ll give a numerical example. The stimulus isn’t actually saying that high scorers have the worst odds of paying back money. It’s saying they have the worst odds when actually given a loan.
So let’s say some potential borrowers owe money to the mob. In that case, the borrowers will always pay the mob before the bank. The bank sends you stern letters, but the mob breaks your legs.
So, answer A is saying that if you have, say, a 745 credit score, then the bank will look at your application carefully, figure out you owe money to the mob, and deny your loan. So with a 745, you only get a mortgage if you’re clean. But 745 is a good score, so you’re unlikely to default if you’re clean.
Whereas suppose someone has a score of 845. Here, the bank goes gaga and gives out loans left and right, without checking the files, jumping for joy and saying “I can’t lose giving a mortgage to these people!”. And of course, some in that group have well hidden debt to the mob, and they pay the mob before the bank.
So because the bank was careless when approving mortgages to those with higher scores, the overall risk to that group is higher. Even though overall those with scores of 845 are better bets. It’s just that even the bad bets with a 845 got a mortgage, whereas only the good bets with a 745 got a mortgage.
___________
- CORRECT. This means that lenders overfocus on credit scores when the scores are really high. Lenders ignore the other non-credit score risks, and these risks could explain the defaults.
- Every set of data has errors! It doesn’t mean the data isn’t useful. For example, law schools use applications to judge applicants. And yet law school applications: “sometimes include errors or omit relevant information”.
That doesn’t make law school applications useless! No data is perfect. But data can be useful if it’s 85% accurate, 90% accurate, etc. So this answer doesn’t help show credit scores are useless or misleading or anything. - This makes things more confusing. It shows that people with high scores were good at paying off debts. So why are they failing now?
- This explains why loans are hard to pay off for people in general. It doesn’t explain why those with high credit scores have the most trouble paying off mortgages.
- This doesn’t explain anything. We would expect most people to be in the middle, not at the top or bottom. This doesn’t explain why the top is riskier than the bottom.
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