How do You Stack Up—Credit Wise?
The average U.S. consumer has:
Eleven credit accounts, of which seven are credit cards
A 20 percent chance of having a delinquency report
A total debt of $5,000 or less
A 13-year credit history
Free Credit Reports:
Massachusetts residents have access to free credit reports from the three big bureaus – Equifax, Experian and Trans Union. This free access should help consumers keep track of any inaccuracies or omissions in their credit files that could depress their credit scores and raise the cost of the mortgage money they need to purchase a home.
This central site allows you to request a free credit file disclosure, commonly called a credit report, once every 12 months from each of the nationwide consumer credit reporting companies: Equifax, Experian and TransUnion.
Credit Scoring Issues
Credit scoring has become a serious issue in the lending community and it can affect your ability to obtain or refinance your next mortgage. Credit scoring systems can gauge a mortgage applicant’s credit rating and assign an interest rate and risk value based upon information provided in the loan application. It offers several advantages – quick recommendations while taking human judgment out of the equation, efficient and, usually, inexpensive.
Feature Story from REALTOR Magazine
Quick loan approval or busted deal—
a buyer’s credit score can be the deciding factor.
BY CHRISTOPHER M. WRIGHT
Why do practitioners need to worry about a technical subject like credit scoring? Because without a good credit score, it’s hard for buyers to get a mortgage. And without a competitive mortgage, they’re much less likely to buy a home.
But if you’re savvy about credit scoring, you can help your customers make sound choices about their financing options—saving time and frustration for all.
Thirty years ago, credit scoring was used only for credit card and auto loan applications. It came to the home-ownership sector only about ten years ago, when mortgage insurance companies, taking advantage of technology changes driven in part by the two secondary mortgage market entities, Fannie Mae and Freddie Mac, started using them. The scores have been widely used in mortgage loan applications since about 1995.
What is Credit Scoring?
At its most basic level, credit scoring is a calculation based on information contained in a person’s credit report. The calculation by a credit bureau sums up how well an individual has managed credit.
The purpose of the calculation is to create a numerical score, which is intended to help lenders determine quickly and objectively whether a loan applicant is a good credit risk and has the ability to repay the loan. The score also helps lenders decide what loan product is most appropriate for the borrower and what interest rate to charge.
By itself, a credit score doesn’t determine whether someone gets a loan. Lenders also consider factors such as a person’s income and debt load to arrive at mortgage score.
Mortgage scoring is largely an automated process, today, thanks to the two giant secondary mortgage market companies, Fannie Mae and Freddie Mac. Because these two buy the bulk of the home loans that lenders originate, lenders almost universally accept their qualification standards.
Credit Scoring Factors
The most common credit-scoring model today is by Fair, Isaac & Co. (FICO). It’s used by the big three national credit repositories, Equifax, Experian, and Trans Union. Some national lenders and mortgage insurance companies use their own scoring formulas.
Whichever model is used, the credit score is calculated using information in a person’s credit report and a proprietary mathematical equation. Based on patterns identified in hundreds of thousands of sample reports, the equation assigns weights to various factors, such as late payments and amount of debt. The precise methodology is secret, although FICO has recently made some of the details available on its Web site myFICO.com.
Credit scores typically range from 300 to 900, with a higher score indicating a better credit risk. Lenders set their own cutoff points, but 720 is considered a good score, says Jalma Hunsinger, president of American Homebuyers Inc., Tempe, Ariz., and vice chair of the NATIONAL ASSOCIATION OF REALTORS’ Conventional Finance Committee. Fannie Mae recommends that loan originators give applicants with scores between 620 and 660 a second look to confirm that the applicants aren’t eligible for the best financing terms.
A buyer’s credit score can affect the interest rate and other terms of the loan. In the Fannie and Freddie automated underwriting systems, approved borrowers fall into two categories. “A-paper” borrowers receive the best interest rate and “A-minus paper” borrowers initially pay up to 250 basis points higher. This rate can be lowered later if payments are made on time.
Applicants with marginal scores are sometimes asked to put up higher down-payments, as much as 30 percent in some instances, Hunsinger says. Or they may have to borrow in the sub-prime market and pay higher rates, origination fees, and closing costs.
Credit Score Components
In general, FICO scores are based on five categories of information:
Payment History (35 percent): Have applicants paid their credit obligations on time? How often, how recently and for how long an applicant has been delinquent counts heavily. “Public record” and collection events such as bankruptcies and foreclosures are also considered, but their importance is lessened if the amount is small or they’re in the distant past. Still, lenders can disqualify an applicant based on a bankruptcy or other single piece of information.
Amounts Owed (30 percent): How much does a person owe and how many accounts does one have open? The model looks for people who are becoming overextended and sniffs out risk in situations where people have never ever missed a payment. Rising balances, maxing out on credit cards, seeking new credit, and high balances on installment loans are considered good predictors of future trouble.
Length of Credit History (15 percent): How long has an individual had established credit? In general, the longer the credit history, the higher the potential score. The age of your oldest account, the average age of all your accounts, and how long since you’ve used certain accounts are among the items scored.
Types of Credit in Use (10 percent): What is a borrower’s mix of credit sources? All credit sources are not created equal. Having credit cards and a history of timely payments, for example, will raise one’s score. Applicants with no credit cards are considered higher risk than people who have shown they can manage credit cards responsibly. Conversely, dealings with finance companies can lower one’s score because such companies charge higher interest and this is not considered good credit management.
New Credit (10 percent): What’s an applicant’s recent credit activity? Every time a person applies for credit, the lender or credit card company checks the applicant’s credit history and another “credit inquiry” is notched on one’s report. That reduces a person’s score. But after being criticized for penalizing borrowers who shop around for the best rate when trying to open a new account, FICO has made changes that aim to distinguish rate shoppers from people seeking to open multiple lines of credit. For example, mortgage inquiries made in any 14-day period count as a single inquiry.
FICO provides up to four “reason codes” explaining reasons for deductions from an applicant’s score. This provides clues on how to improve your score in the future and may give an indication of an error in your credit report.
The most frequently given reason codes include:
· Serious payment delinquencies
· Frequent or recent payment delinquencies
· Bankruptcies and collections in the public record.
Other common reason codes are the proportion of the balance on a credit card to the overall credit limit and an excessive total amount owed.
Repairing Your Credit
Fortunately, a low score doesn’t have to follow borrowers around forever. As they lower their debt and improve their payment histories, scores will improve. What’s more, there are steps borrowers can take to get on the road to repaired credit.
Borrowers who need to improve their scores can also try these strategies.
Wait a full 12 months after you’ve had credit difficulties to apply for a mortgage. Some items are scored less heavily after 12 months.
- Don’t order home furnishings or appliances during the mortgage application process even if the first payment is not due for some months later. The balance you owe will be counted as part of your debt when the loan application is reviewed.
- Pay off back taxes in a lump sum, not installments to reduce your overall level of debt.
- Avoid finance companies, which charge high fees and rates. Their use is considered indicative of poor credit management, even if the borrower pays the loans back on time
- Do rate-shopping all at once. Multiple inquiries from the same type of lender are scored as a single inquiry if received within a short period of time.
- Don’t open a lot of credit card accounts quickly to build a credit record. Doing so lowers the average account age and looks risky to the scoring model.
- Pay down credit card balances. However, off-load crediting card debt to a new card with a lower interest rate is not considered good credit management and also results in another credit inquiry that will lower your score.
- Closing credit-card accounts is not effective at improving your score and may actually lower it. The FICO model compares the amount of debt you are carrying to the total amount of credit available. Shutting down accounts will thus raise the debt-to-credit ratio, lowering your score. Second, shutting down the oldest accounts will reduce the average age of the accounts, which also subtracts from the score.
In some cases, credit problems or errors in credit reports may be severe enough to require the help of a credit counselor. But buyer beware: “Some ‘credit cleaning companies’ are disreputable and collect money from desperate people with no intention of trying to clean up their credit,” says Judy Zeigler, CRS, GRI, an associate with Prudential California Realty, Palm Desert.
Even fixing errors on one’s credit report can take a long time. Each local credit reporting agency must be convinced, and some creditors update information slowly. “Lots of times things are incorrect on the credit report. That’s why it’s important to check your report yearly,” says Irene Mabry Moses, ABR, an associate with Allen Realty, Baltimore.
Flaws in the Model
Because of the time and money saved by automated mortgage scoring, the use of credit scores is here to stay. But they’re not without their critics.
The model can lead to an assembly line process that, as Zeigler sees it, “doesn’t leave much room for human judgment.” The outcome of the process is an “accept” or “caution” rating.
Fannie Mae encourages underwriters to consider extenuating circumstances and evaluate all relevant risk factors if credit deficiencies negatively influence scores. But a “caution” rating is often all it takes to have a loan denied. Lenders just don’t have the time to work with marginal cases, Hunsinger says.
The loss of individual attention can be a problem for people who have inaccuracies on their credit report. Nor is credit scoring exempt from concerns over bias. “Some buyers are eliminated immediately because of their saving and credit habits,” says Zeigler. “That can disproportionately hurt members of cultural groups or recent immigrants who don’t use traditional credit and have no existing credit score.”
On balance, however, credit scoring is proving a good thing, Hunsinger says. It has led to more predictable mortgage performance and opened up the market to new home-buyers, including lower-income households that would not have qualified under the old system.
Like it or not, it pays to know what credit scoring is all about if you plan to assist buyers in obtaining mortgage financing.
Reprinted from REALTOR® Magazine [April, 2002] (http://www.realtor.org/realtormag) with permission of the NATIONAL ASSOCIATION OF REALTORS®. Copyright 2005. All rights reserved.