- The Washington Times - Thursday, January 27, 2011

Decades ago, consumers who wanted to buy a home had to meet with their local banker, prove they had the income and assets required to purchase property and make a substantial down payment before obtaining approval for a home loan. Today’s homebuyers may have the option of making a lower down payment, but they face a more complex mortgage-approval process.

The No. 1 factor influencing mortgage qualification these days is the consumer credit score, also known as a FICO score, invented by the Fair Isaac Corp. While debt-to-income ratios and the availability of funds for a down payment and closing costs also have an impact on a loan decision, lenders use an automated underwriting system that depends heavily on consumer credit scores, which range from 350 to 850.

In recent months, mortgage giants Fannie Mae and Freddie Mac have increased fees that borrowers must pay for a variety of factors, including a credit score lower than 740. Many lenders have raised the minimum required credit score for an FHA-insured mortgage to 620 or higher. The FHA requires borrowers with a FICO score of 580 or less to make a larger down payment, although few consumers with a score that low can find a lender to approve them for a loan.

Not only may a loan be approved or denied based on the credit score, but in recent years, lenders have begun using risk-based pricing, meaning that the mortgage interest rates consumers pay are on a sliding scale tied to their credit score.

“Credit scores have proven to be good predictors of the risk you are taking giving someone money and then expecting them to pay you back,” says Barbara Sheehan, assistant vice president for mortgage products for the Navy Federal Credit Union in Merrifield, Va. “Those with a higher score have a higher probability to pay you back. Those with a lower score have a higher probability of not paying you back. Their debt history is a predictor of their future.”

While the focus on credit scores seems relatively new, the FICO score actually was developed decades ago.

“FICO scores were created in the 1940s, but it took a long time, and the scores’ reliability needed to be improved before mortgage bankers started to use them,” says Johnathan Thomas, vice president of residential lending for Virginia Commerce Bank in Chantilly, Va. “The reason credit scores carry so much weight now is that Fannie Mae and Freddie Mac have had enough time and data to study loan performances by consumers with different credit scores.”

Mr. Thomas says FICO scores enable lenders to look at the big picture of a borrower.

“Now lenders can not only look at how well individuals pay their debts, but also, if they get credit from a certain lender or bank that is known to be a lender of last resort for people with financial problems, that can hurt their score and be an indication of potential foreclosure risk,” Mr. Thomas says.

Clearly, lenders are trying to avoid having too many loans go into default and are particularly wary of this because of recent waves of foreclosures. Ms. Sheehan explains that the heavy reliance on credit scores comes from Freddie Mac and Fannie Mae and mortgage investors as well as from the lenders themselves.

“The agencies and investors that buy the loans and securitize them set the credit score requirements,” Ms. Sheehan says. “If the consumer doesn’t have the right score, the lenders cannot sell the loan and replenish funds so that they can loan to the next person.”

Each consumer has three credit scores, one from each of the three major credit-reporting bureaus, Equifax, Experian and Trans-Union. The three scores vary because each bureau may have slightly different information and may weigh certain factors in a slightly different way. Lenders generally pick the middle of the scores to use for loan applications.

In 2010, FICO introduced a new scoring system known as the FICO 8 Mortgage Score. Although it is not widely in use yet, particularly because the new score has not been implemented for use by Fannie Mae or Freddie Mac, some banks are using the FICO 8 score as a secondary check on mortgage loan applicants to be more certain of their creditworthiness. Eventually, FICO anticipates that most lenders will use the FICO 8 Mortgage Score rather than a standard FICO score.

According to www.fico.com, the FICO 8 Mortgage Score provides lenders with a better prediction of the possibility of a mortgage default. Scores are in the same range (350 to 850) as traditional FICO scores, but the score is weighted more heavily by payments that are 90 days late or longer and mortgage and/or rental payment performance.

Gregg Busch, vice president of First Savings Mortgage Corp. in the District, says, “The new score places more emphasis on the likelihood of someone going into foreclosure than other credit issues. So, for example, one small late payment will not lower the FICO 8 score as much as it does the regular FICO score. A more significant drop in the score would come from high credit users who max out their credit cards, because they are a greater risk for getting in over their heads financially.”

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