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."
Since 2007, Fannie Mae and Freddie Mac, and therefore most lenders, have offered consumers tiered mortgage rates based on their credit score. In recent years, most lenders will charge a slightly higher interest rate for borrowers with a credit score under 740. The size of the increase depends on the credit score, so there are tiered interest rates for borrowers for each 10- to 20-point change in score. For example, a borrower with a credit score of 740 could pay 4.59 percent interest, while a borrower with a credit score of 640 would be required to pay 5.41 percent, according to www.myfico.com.
Fannie Mae and Freddie Mac announced additional fees for mortgage borrowers at the end of 2010, including some tied to credit scores and others related to the type of property being purchased. Many lenders recently implemented these changes in their loan programs.
"Consumers with a credit score under 740 will be charged an additional quarter point at the closing or they can opt to pay the fee in an interest-rate increase of one-eighth percent over what they would otherwise pay," Mr. Busch says.
"Loan prices will also go up for people who want to refinance if they have a home-equity loan that they want to keep," he says. "The biggest impact will be felt by people with scores under 700 with less than 20 percent equity when refinancing, or who make a down payment of less than 20 percent, because they will have to pay a half-point at closing or see their interest rate go up by quarter percent."
One point is equivalent to 1 percent of the loan amount, so borrowers who must pay a half point on a $400,000 mortgage would pay $2,000 at the closing.
Mr. Busch says consumers have the choice of paying the fee at the settlement or opting for the increased interest rate.
"Another change is that while buyers making a 25 percent down payment (or with 25 percent equity when refinancing) and decent credit were not charged anything extra in the past, the threshold is now 30 percent," Mr. Busch says. "If you make a down payment of less than 30 percent, the loan costs will be one-eighth percent higher in interest or a quarter point at settlement.
"Basically Fannie Mae and Freddie Mac are increasing interest rates on everyone without 30 to 40 percent equity and stellar credit. Even people with a great credit score will have to pay more if they don't have a lot of equity."
The best scenario for consumers is to raise their credit score as much as possible by paying off debt and paying all bills on time. New rules that went into effect Jan. 1 require lenders to provide all consumers with a disclosure that explains why they are qualified at a particular interest rate.
"For people with a low credit score, this disclosure letter can be enlightening, but for the most part, a lender will have already discussed any credit issues with the borrower at the time of a loan application," Mr. Thomas says.
Credit scores are renewed once per month, but improvements to a score, depending on the reason for a lower score, can take months to appear, or even years in the case of a judgment or bankruptcy. Borrowers who cannot wait for an improved credit score likely will have to pay a higher interest rate and possibly more in fees at settlement to qualify for a mortgage. Depending on the score, some borrowers will not qualify at all.
"If a consumer does not improve their credit score before applying for a loan, they will have to pay a higher price to borrow money," Ms. Sheehan says. "This is true whether it is a credit card, a car loan or a mortgage. They are a higher risk and lenders will only lend if they can cover this potential risk."
Mr. Thomas says borrowers sometimes can qualify for a loan if they have additional cash and can make a down payment of 40 percent or more.
"Most lenders have a category of loans for people who will make a bigger down payment, but even so, they may have to pay a higher interest rate because of their credit history," Mr. Thomas says.
Ms. Sheehan agrees that the extra down payment will not change the higher price borrowers must pay if the buyer has a low credit score.
"A lower FICO score will mean even when you put 20 percent down, the pricing will be higher if your score is low than it would have been if your score is high," Ms. Sheehan says.
Mr. Busch says all consumers need to be aware of their credit score and address this issue first before applying for a loan. Consumers can get a free copy of their credit report each year from each credit reporting bureau through www.annualcreditreport.com, but must pay a fee to learn their credit score. Many websites offer free FICO scores, but the score often comes with a subscription to a score-monitoring service.
"Credit-repair companies can help you if you don't have the time to follow up on mistakes on your credit report or need some advice," Mr. Busch says. "But the first thing everyone needs to do is limit their use of credit and try to get each credit use under 50 percent of the credit limit."
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