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What is credit scoring?

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What is Credit Scoring?

This is for background purposes and is not to be reproduced or distributed.

Credit Scoring is quite simply a manner of statistically analyzing and grading your credit history. Credit scoring seeks to apply a number to your credit history for the purpose of determining your potential credit risk. The credit score allows a lender to predict the potential performance of any loan made to a borrower.

Credit scores have been in use since the late 1950’s, however, they have only become an integral part of the mortgage process since late 1995 and early 1996. This is when the mortgage industry started to utilize the credit scores in an effort to increase the quality of mortgage application approvals. As the process has been refined the scoring becomes more relevant to loan loss prevention.

Each of the three major credit repositories; Equifax, Trans Union (TU) and Experian (TRW) produce their own credit scores. Each credit repository uses a slightly different criteria model, therefore each of the three repositories will present three different credit scores. Many lenders will “pull” (request) a credit report from each repository to acquire the three credit scores and use the middle credit score. If an application contains both a husband and wife or the application has multiple borrowers, often the middle credit score of the lowest rated borrower will be used to determine the credit worthiness of the borrowers. Co-signing on a loan is no longer an absolute positive to the lending criteria.

Credit Model Criteria

Each credit bureau uses different factors for their models. These factors range from 33 variables to over 100 variables. In early 2017 the credit agencies began to report the amount of the monthly payments made by a borrower. It is not a negative to make the minimum, but it is a positive to pay more than the minimum required payment, and the reports will reflect these payments.

Generally, all of the variables of the model can be broken down into five categories:

  1. Credit History: This is a snapshot of the short-term (12-24 months) payment history and the long-term (2yrs – 7yrs) payment history. The short-term is more heavily weighted.
  2. Percentage of current indebtedness: The computer models heavily factor your credit available versus your current outstanding credit balances, as a percentage. Any revolving account with a balance over 40% begins to lower the credit score.
  3. Age of Accounts: The length of time an account has been open bears weight on the credit score. A borrower with five perfectly performing accounts might have a low score if all the accounts are less than two years old.
  4. Types of Accounts: The criteria weights the value of accounts from highest to lowest in the following manner; mortgages, auto loans, installment loans to revolving and credit cards.
  5. Inquires: A large number of inquiries on a credit report will have a negative effect. It is a sign the borrower is attempting to acquire debt and it is therefore difficult to determine who has granted the borrower debt and for how much. Inquiries are usually removed after a three month period. Each model also allows for shopping for a mortgage.

These are the primary, but not the exclusive factors utilized to determine an individuals’ credit score.

Credit Scores

Credit scores have a range from 400 up to 900 (although most of the mortgage profiles reach a max. score of 900). Pre- 2007 collapse, Fair Issac & Co. had reported that Credit Scores below 620 will be seriously delinquent or fall into foreclosure for 1 out of 8 loans granted. Credit Scores between 700-719 will be seriously delinquent or fall into foreclosure only for 1 out of 123 loans granted. Credit Scores above 770 will have only 1 out of 1,292 loans that will be seriously delinquent or fall into foreclosure.

To be a safe risk on an FNMA (Fannie Mae) fully documented mortgage application; the borrower will need a credit score of 620 or higher. In 2013, the economic environment caused many lenders to have a minimum score of 640. A score above 700 will generally assure that a borrower’s mortgage application will proceed free of most credit problems. Generally, Fannie Mae and Freddie Mac will not accept credit profiles that are below 620 without major compensating factors.

Why does your credit score matter?

Loan Level Pricing Adjustments is the simple answer. These are charges to the points or interest rate mandated by Fannie Mae, Freddie Mac, and FHA. These fees could be as much as 3 points.

Borrowers with a credit score above 700 will be granted greater flexibility in the underwriting of their file. An underwriter will be more willing to approve an applicant’s file with a “back-end ratio” of 43% when the credit score is on the higher end of the range. Many lenders will allow the underwriter to avoid needing a second signature when the borrower has a 700+ credit score.

Caution is the course of action followed by many investors when the credit scores are between 620 and 640. Often other compensating factors are required to build the quality of the file as a whole. Any credit score below 620 would immediately raise a red flag and would most often because for loan denial from a program underwritten to Fannie Mae or Freddie Mac guidelines.

Is This A Fad?

Expect credit scoring to remain and grow to be a primary facet of the real estate lending industry for years to come. The accuracy of credit scoring has been improving with every mortgage payment. Loan loss mitigation or prevention is paramount to the industry and the nation as a whole.

Fannie Mae, Freddie Mac, FHA, and VA will continue to purchase, back insure or guarantee billions of dollars in mortgages in the secondary market each year for the foreseeable future. They are the largest sources for mortgages in the nation. The underwriting criteria they set forth will set the guidelines for underwriting and will filter down throughout the industry. Even a major lender who retains their own servicing while selling the mortgages as mortgage-backed securities are pressured to use the Fannie Mae & Freddie Mac underwriting criteria to maintain the ease of sale of the mortgage loan in the secondary markets.

Can A Borrower with a Credit Score Falls Below 620 Still Acquire A Mortgage?

A borrower whose credit score falls below 620 may still acquire a mortgage. There are fewer lenders in this channel after the economic collapse. Many traditional banks and mortgage companies will not lend money to borrowers who have credit scores that are below the 620 level.

Quite often the cause of a low credit score is the result of either excessive debt limits or outstanding judgment’s. If you have credit card debt that exceeds 50% of your credit line, your credit scores will fall. Paying off an outstanding judgment/charge-off / or lien usually will not have an immediate effect on a credit score. One suggestion is to utilize the website and utilize the 5 yr Electronic Opt Out feature.

Only time, low debt percentages and clean payment history can help raise your credit score. The time frame will vary from borrower to borrower. For a fee, some Credit Companies can re-score a report in a few days. Consult your NMLS Licensed Mortgage Loan Originator. Some mortgage companies have credit programs that will inform you of how to raise your credit scores by paying off certain debts and how many points you could see in the short term.

Some lenders will allow a judgment to be paid prior to closing, while other lenders might want a 6-12 month grace period after a judgment is paid in full. Once again consult your NMLS Licensed Mortgage Loan Originator

NOTE: In most situations, borrowers cannot close on a mortgage with outstanding judgments or tax liens.