FICO & your mortgage: Part 1 |
A few years ago, credit scoring had little to do
with mortgage lending . When reviewing the
credit worthiness of a borrower, an underwriter
would make a subjective decision based on past
payment history.
Then things changed.
Lenders studied the
relationship between credit scores and mortgage
delinquencies. There was a definite
relationship. Almost half of those borrowers
with FICO scores below 550 became ninety days
delinquent at least once during their mortgage.
On the other hand, only two out of every 10,000
borrowers with FICO scores above eight hundred
became delinquent.
So lenders began to
take a closer look at FICO scores and this is
what they found out. The chart below shows the
likelihood of a ninety day delinquency for
specific FICO scores.
|
FICO Score |
odds of a delinquent account |
|
|
|
|
|
|
|
595 |
|
2.25 |
to |
1 |
|
600 |
|
4.5 |
to |
1 |
|
615 |
|
9 |
to |
1 |
|
630 |
|
18 |
to |
1 |
|
645 |
|
36 |
to |
1 |
|
660 |
|
72 |
to |
1 |
|
680 |
|
144 |
to |
1 |
|
700 |
|
288 |
to |
1 |
|
780 |
|
576 |
to |
1 |
If
you were lending a couple hundred thousand dollars, who
would you want to lend it to?
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Part 2: How lenders look at them |
Imagine a busy lending office and a loan officer has
just ordered a credit report. He hears the whir of the
laser printer and he knows the pages of the credit
report are going to start spitting out in just a second.
There is a moment of tension in the air. He watches the
pages stack up in the collection tray, but he waits to
pick them up until all of the pages are finished
printing. He waits because FICO scores are located at
the end of the report. Previously, he would have
probably picked them up as they came off. A FICO above
700 will evoke a smile, then a grin, perhaps a shout and
a "victory" style arm pump in the air. A score below 600
will definitely result in a frown, a furrowed brow, and
concern.
FICO stands for Fair Isaac & Company, and credit scores
are reported by each of the three major credit bureaus:
TRW (Experian), Equifax, and Trans-Union. The score does
not come up exactly the same on each bureau because each
bureau places a slightly different emphasis on different
items. The number itself can range from 300 to 900. The
formula for exactly how the score is calculated is
proprietary information and owned by Fair Isaac. Here,
however, is an approximate breakdown of how it is
determined:
35% of the score is based on your payment history. This
makes sense since one of the primary reasons a lender
wants to see the score is to find out if (and how
timely) you pay your bills. The score is affected by how
many bills have been paid late, how many were sent out
for collection, any bankruptcies, etc. When these things
happened also comes into play. The more recent, the
worse it will be for your overall score.
30% of the score is based on outstanding debt. How much
do you owe on car or home loans? How many credit cards
do you have that are at their credit limits? The more
cards you have at their limits, the lower your score
will be. The rule of thumb is to keep your card balances
at 30% or less of their limits.
15% of the score is based on the length of time you've
had credit. The longer you've had established credit,
the better it is for your overall credit score. Why?
Because more information about your past payment history
gives a more accurate prediction of your future actions.
10% of the score is based on the number of inquiries on
your report. If you've applied for a lot of credit cards
or loans, you will have a lot of inquiries on your
credit report. These are bad for your score because they
indicate that you may be in some kind of financial
trouble or may be taking on a lot of debt (even if you
haven't used the cards or gotten the loans). The more
recent these inquiries are, the worse for your credit
score. FICO scores only count inquiries from the past
year.
10% of the score is based on the types of credit you
currently have. The number of loans and available credit
from credit cards you have makes a difference. There is
no magic number or combination of types of accounts that
you shouldn't have. These actually come more into play
if there isn't as much other information on your credit
report on which to base the score.
Sounds confusing, doesn’t it?
The credit score is actually calculated using a
"scorecard" where you receive points for certain things.
Creditors and lenders who view your credit report do not
get to see the scorecard, so they do not know exactly
how your score was calculated. They just see the final
scores.
Basic guidelines on how to view the FICO scores vary a
little from lender to lender. Usually, a score above 680
will require a very basic review of the entire loan
package. Scores between 640 and 680 require more
thorough underwriting. Once a score gets below 640, an
underwriter will look at a loan application with a more
cautious approach. Many lenders will not even consider a
loan with a FICO score below 600, some as high as 620.
FICO Scores and Interest Rates
Credit scores can affect more than whether your loan
gets approved or not. They can also affect how much you
pay for your loan, too. Some lenders establish a "base
price" and will reduce the points on a loan if the
credit score is above a certain level. For example, one
major national lender reduces the cost of a loan by a
quarter point if the FICO score is greater than 725. If
it is between 700 and 724, they will reduce the cost by
one-eighth of a point. A point is equal to one percent
of the loan amount.
There are other lenders who do it in reverse. They
establish their base price, but instead of reducing the
cost for good FICO scores, they "add on" costs for lower
FICO scores. The results from either method would work
out to be approximately the same interest rate. It is
just that the second way "looks" better when you are
quoting interest rates on a rate sheet or in an
advertisement.
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Part 3:
FICO Scores as Guidelines |
FICO
scores are only "guidelines" and factors other than FICO
scores affect underwriting decisions. Some examples of
compensating factors that will make an underwriter more
lenient toward lower FICO scores can be a larger down
payment, low debt-to-income ratios, an excellent history
of saving money, and others. There also may be a
reasonable explanation for items on the credit history
which negatively impact your credit score.
They Don't Always Make Sense
Even so, sometimes credit scores do not seem to make any
sense at all. One borrower with a completely flawless
credit history had a FICO score below 600. One borrower
with a foreclosure on her credit report had a FICO above
780.
Portfolio & Sub-Prime Lenders
Finally, there are a few "portfolio" lenders who do not
even look at credit scoring, at least on their portfolio
loans. A portfolio lender is usually a savings & loan
institution who originates some adjustable rate
mortgages that they intend to keep in their own
portfolio instead of selling them in the secondary
mortgage market. They may look at home loans
differently. Some concentrate on the value of the home.
Some may concentrate more on the savings history of the
borrower. There are also "sub-prime" lenders, or "B & C
paper" lenders, who will provide a home loan, but at a
higher interest rate and cost.
Running Credit Reports
One thing to remember when you are shopping for a home
loan is that you should not let numerous mortgage
lenders run credit reports on you. Wait until you have a
reasonable expectation that they are the lender you are
going to use to obtain your home loan. Not only will you
have to explain any credit inquiries in the last ninety
days, but numerous inquiries will lower your FICO score
by a small amount. This may not matter if your FICO is
780, but it would matter to you if it is 642.
Don't Buy A Car Just Before Looking for a Home!
In conclusion, a word of advice not directly related to
FICO scores. When people begin to think about the
possibility of buying a home, they often think about
buying other big ticket items, such as cars. Quite often
when someone asks a lender to pre-qualify them for a
home loan there is a brand new car payment on the credit
report. Often, they would have qualified in their
anticipated price range except that the new car payment
has raised their debt-to-income ratio, lowering their
maximum purchase price. Sometimes they have bought the
car so recently that the new loan doesn’t even show up
on the credit report yet, but with six to eight credit
inquiries from car dealers and automobile finance
companies it is kind of obvious. Almost every time you
sit down in a car dealership, it generates two inquiries
into your credit.
Credit History is Important
Nowadays, credit scores are important if you want to get
the best interest rate available. Protect your FICO
score. Do not open new revolving accounts needlessly. Do
not fill out credit applications needlessly. Do not keep
your credit cards nearly maxed out. Make sure you do use
your credit occasionally. Always make sure every
creditor has their payment in their office no later than
29 days past due.
And never ever be more than thirty days late on your
mortgage. Ever!
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