A Close Up Look at Credit Scoring

Five years ago, FNMA and FHLMC began recommending the use of credit scoring as an underwriting tool. There had been no training regarding credit scoring for mortgage brokers or mortgage bankers and there was little understanding of the process.

Originators who heard about the scores being based on raw credit repository information went ballistic! Every forum on credit scoring found the members of FNMA, FHLMC, and Fair Isaac under massive verbal attack. Mortgage brokers were up in arms, and it wasn't very long before their fear that lenders would arbitrarily reject loans below 620 (regardless of the significant errors on the report or too many inquires) began to materialize. The brokers couldn't determine how to read the information - what was impacting the score? Why, if there were no late payments reflected on the report was the credit score so low? If a piece of information was incorrect, how fast could you correct the score when you eliminated the error? Brokers felt out of control. That situation was not enhanced by the secondary market repeatedly telling brokers that scoring was just one tool in the underwriting process or Fair Isaac telling brokers that their statistical model was proprietary, so they couldn't tell the brokers how to interpret the report.

A broker had previously been able to read a credit report, identify any issues, and use the credit report to counsel the consumer about his or her options. Based on the verified information, the broker then knew exactly what documentation was needed to overcome the issue and gain loan approval. Originators were screaming that a borrower's credit report was perfect, but the score was low. The score had to be wrong. Looking back now, it was almost always a lack of knowledge that generated that conclusion.

Over the last five years, I would like to believe our industry has become more knowledgeable and more accepting of the secondary market's use of credit scoring as a tool for accessing and managing risk. Indeed, many in our industry have worked hard to gain a better understanding of credit scoring so that they can better advise, educate, and server the consumer. Unfortunately we still have those in our industry who still have failed to avail themselves of the in-depth training available about credit scoring, choosing to cry foul and direct many consumers to subprime loans when there is no need. Consequently we still have many brokers frustrated and confused with the risk management tool that the secondary market has so thoroughly embraced. Most originators still believe that if the credit report is "perfect" (no lates), he or she should be able to get the loan approved, regardless of a low score, for the best rate. The acceptance of credit scoring as a risk management tool requires an originator to step back and look at the big picture regarding an individual's credit profile. To that end, this article will try to provide some answers about credit scoring and some additional information about the latest changes in scoring models and ways to assist your consumer in their understanding of scores and their own personal profile.

A Credit Score Definition

Fair Isaac defines a credit score as a snapshot of an individual's credit at any given time. The score changes as new information is added to or deleted from the individual's credit file at the repository. Credit scoring is only one of several pieces of information that the lender utilizes to help them quickly and objectively determine an individual borrower's ability to repay his/her loan, but it is not in and of itself a "yes" or "no" answer. Before the utilization of scoring, the credit granting process could be slow, inconsistent, and on occasion unfairly biased. Not every repository has the same information, so credit scores can vary, sometimes significantly, from one repository to another, potentially creating an indicator of higher than actual risk, if an investor only uses one repository score in its underwriting process.

There are many different types of credit scores. It could be a score calculated by a computer at a bank for a credit card, a bankruptcy score, or a score by a Fair Isaac scoring model at one of the three major credit repositories. FICO scores are based on the information stored in a consumer's credit file at a specific credit repository at the time the report was issued. There is no good or bad credit score to achieve, the score is an indicator of risk and lenders offer many different types of loan product geared to different risk levels. Today, a borrower may receive significantly improved pricing, and reduced documentation if his/her credit score is above a specific threshold, 680 or 720 for example.

Weighting of Scores

Scores are based on five main types of credit information. Past payment performance such as late payments, collections, judgments and bankruptcies, past due amounts, and tax liens account for approximately 35 percent of the weight of the score. Credit utilization or the amount of outstanding debt weighs in at approximately 30 percent of a consumer's score. The length of a consumer's credit history (how long accounts have been open) accounts for approximately 15 percent of the score. Inquiries or applications for new credit equal approximately 10 percent of the score. The type of credit (revolving versus finance company accounts, etc.) used equals 10 percent. Originators can recognize which type of credit information is negatively impacting the borrower's score by referring to the reason of factor codes that are issued along with the scores in the report.

The definition of the reason codes were revised a few years ago by Fair Isaac (at the request of the National Association of Mortgage Brokers committee) to assist originators in explaining to or counseling the consumer regarding the management of his/her credit. Based on the calculations performed on each of approximately 40 different variables of a credit record, score factor codes are determined. The calculation method makes it possible for a factor or reason code to be evoked even when the credit record scores high. For example, the number of revolving accounts with balances means that the total number of bank or revolving trade lines that have a balance is greater than it could be, not that it is bad. This calculation is the difference between the maximum score possible on a particular variable and the actual sore for the particular variable in the report. Score factor codes on higher scoring records are obviously not as meaningful as lower scoring records for a particular variable.

Explanations can be requested from your local credit reporting agency, or you can go to a new website developed by Fair Isaac to help originators and consumers with better understanding of their scores and reason codes. The site is called FicoGuide.com. Once you have registered on this site as a user, for $8, you may key in the credit scores and four reason codes from each repository and get an in depth explanation of those codes in lay person language. The explanation will address how that consumer's credit profile ranks as compared to all other consumers with credit nationally, how the lender might look at that consumer's credit profile from a risk perspective, and what the consumer might do to improve his or her credit profile over time. As more sates like California pass legislation that require originators to explain how credit scoring is used in underwriting the consumer's loan application, this site will become a very valuable tool for the originator who isn't comfortable explaining how a score is derived and its impact on consumers.

Factors Not Included

What's not in the score? US law is very specific about what cannot go into a credit score without being in direct violation with federal law. Information regarding race, religion, gender, marital status, the consumer's job position, income earned, height, weight, type of neighborhood, or birthplace may not be included. There has been a lot of concern regarding discrimination of minorities by the scoring system. However it is important to remember what information is used in calculating a consumer's score, and to recognize that only the information stored in the credit repository report is considered in the score. By reducing judgment reviews, scoring promotes fair lending. Credit usage and payment performance are the key factors. In other words, at a given score, all minority and non-minority applicants are equally likely to "pay as agreed".

Counseling Borrowers

How can you counsel borrowers about improving their credit profile? The score reflects the borrower's credit payment patterns over time with the most emphasis placed on recent information, the last 24 months being the most critical. For the borrower to improve his or her credit profile over time, he or she needs to pay their bills on time. Delinquent payments and collections can have a major negative impact on the score, particularly any recent late payment, judgment, bankruptcy, collection or charge-off. Remember that scoring is the assessment of risk, the more recent the derogatory credit entry, the heavier its impact on lowering the score. Never have a consumer payoff an outstanding collection lien or judgment before the close of escrow, you will drive their score down by bringing an old derogatory item with less impact on their score to a current derogatory item with major negative impact on their score.

The balances on outstanding revolving debt should not exceed 30 percent of the consumer's available credit limit on a particular credit card. High outstanding balances can have a major negative impact on the score, as they represent higher risk than accounts with lower credit utilization. By paying down, but not closing the account the consumer will improve the percentage of current balances to the potential high credit balance. Paying off revolving debt before installment debt will have a more significant impact on raising the borrower's score. Please note, however, arbitrarily consolidating credit balances and closing accounts often will have a negative impact on the score as it skews the picture of a consumer's credit utilization. For instance, your consumer has five credit cards each having a $5,000 high credit limit and four of those cards each have a $1,000 outstanding balance owing. The consumer is using approximately 16 percent of available credit. Now, you as the originator instruct your consumer to consolidate all of his or her cards to just one card and close the other cards. Sounds like a good idea until you do the math and the score goes down. Why would the score go down? You have just instructed the consumer to do something that artificially skews the percentage of credit utilization by the consumer from 16 percent to 80 percent, which obviously represents a higher risk than a consumer using less than 30 percent of available credit.

Consumers should apply for new credit sparingly. "Credit surfing", the practice of moving balances from one card to another in order to save interest, has become a very popular practice. The consumer feels he or she is saving interest, thus practicing positive financial sense. The fact is "credit surfing" can cause the scoring snapshot of the consumer's credit to appear that a consumer is in the hunt for additional credit, particularly when other cards are at or close to their maximum limits. Surfing can have very little short-term benefits in interest savings by the time the transfer fee (usually 2 percent) is factored in, but a negative impact to the consumer's score. This practice can cause the "snapshot" of a consumer's credit to indicate outstanding balances on accounts that were moved to another card, but have not yet been reported as zero. The result is a report indicating high outstanding balances, which in actuality do no exist. Those balances would negatively impact the score by artificially skewing the information in the consumer's credit file to reflect higher than actual credit utilization.

Consumers should be aware that finance company lines could have a more negative impact on their credit score than a bank or department store entry under types of credit. Interestingly, the system has now been fine-tuned enough to know the difference between the 90-day same a cash finance company and the hard money type finance company. Those 90-day same as cash entries are treated more like bank cards in the scoring process. It is important to note that a consumer's score is not going to be dramatically lower due to finance companies unless the consumer's credit is predominantly granted through finance companies.

Too Many Inquiries

What if the borrower has too many inquiries or erroneous information on the report? Inquiries continue to be one of the most misunderstood variables of the credit scoring models. Many originators blame low scores on the inquiries on a report. Most originators forget that inquiries only make up about 10 percent of the consumer's score and that unless the first reason code for a score on their report is "too many inquiries", the originator needs to look to other problems on the report for the low score. Years ago, originators complained that the consumer was being prevented from actively shopping for the best interest rate for themselves because of the negative impact multiple inquiries could have on their score.

When lenders ran their quality control report after a file had been submitted for final approval, particularly on seconds, originators watched scores drop below required benchmark levels and often cost the borrower higher interest rates and fees. The members of the National Association of Mortgage Brokers Credit Scoring Committee used every opportunity in front of FNMA, FHLMC, and Fair Isaac to advocate, on behalf of consumers, changes to underwriting policy or an adjustment in the scoring model de-duplication period for counting inquiries. Fair Isaac indicated that multiple inquiries stopped impacting the score after seven, be we still weren't satisfied. Fair Isaac finally listened. They went back to their researchers, instructed them to run their statistical tests for prediction repayment risk utilizing the changes that we had requested. I am pleased to report that not only did our requested changes not diminish the predictive ability of the score, the changes actually enhanced the score. At this time, all auto loan and mortgage inquiries are "de-duped"; counted as a single inquiry, if hey occur within a 14-day period of time. In addition to the lengthy of the de-duplication period, there is now a mortgage inquiry buffer in place to prevent any mortgage or automobile inquiry run within the previous 30 days to the originator / lender's inquiry from negatively impacting the score. Now when an originator runs a credit report on a consumer applying through his or her company to help decide on the proper loan product, the consumer will not be negatively impacted when the wholesaler runs its quality control credit report upon submission of the application package. The wholesaler's report will reflect all the inquiries run, but the consumer's score will not be negatively impacted, causing the consumer to be charged higher rates or fees. It is critical to note, if the lender's credit reporting vendor is using an older version of Beacon from Equifax (earlier than Beacon 96) these inquiry buffers will not be in place and the consumer's score will be lower than the originator's report.

You've Got Errors

Consumers should be counseled to take a look at their own personal report once a year or at the very least 90 days prior to buying a home. If there are verifiable errors on the report, suggest to the borrower that he or she complete a credit dispute form. One for each item per credit repository, attach any necessary proof and send it (return receipt requested) to the individual repository in which the error was listed or go to the specific repository's website and file the dispute online.

If the error is discovered while a consumer is applying for a home loan, there is now a faster method, 24 to 72 hour turnaround time, to affect corrections called Rapid Resolve, Credit Score Plus, or Quick Check. Most of the credit report vendors today can provide the originator this added service for a fee, just like the service of providing an RMCR report. The charge for this service varies from vendor to vendor depending on their hard cost, check with your particular credit report vendor.

Despite many credit report vendor's misinterpretation of the rules in their contract with the repositories, they can charge you, the originator, for the service and you, the originator can charge the consumer for this service. This is a business to business transaction, not a business to consumer transaction. To take advantage of this service, the consumer must provide the originator with very clear proof that an item is in fact an error. A paid in full receipt for a specific item, a full copy of a bankruptcy discharge or a satisfaction of judgment, a tax lien release or a letter from a trade line on its specific letterhead. The letter must specifically identify the consumer and the account number and exactly what modification or deletion is to be made to the consumer's credit file at the specific repository. Vague or ambiguous letters will not work. Once you have that information sent to your credit report vendor, they will validate the information and forward the information to their contact at the various repositories. The repository contact will revalidate the information, then change the information electronically in the actual consumer file stored at the repository and then verify with your credit report vendor that the change has been made. Within five business days the originator can for an additional credit report fee run a new credit report and get scores based on accurate information. Assuming no new derogatory items, higher balances or new accounts being reported the scores generally go up. The extent of the change in the score will depend on the significance of the inaccuracy being corrected. For instance, accounts included in a bankruptcy that have very old dates of last activity will probably have little impact on the score just by showing a zero balance on the account.

The availability of this process is a major improvement in the consumer's ability to have changes to their credit files made as quickly as possible when accurate credit scores are a must. If however, a consumer has scores that are acceptable for the loan product and rate the consumer wants, do not attempt any corrections to the consumer's credit files prior to the close of the loan for which the consumer is applying, regardless of any inaccuracies being reported. The score could go down.

Problem Areas

What are some potential problem areas? If a borrower is divorced and still has credit reported in their name by a trade line, despite the fact that the ex-spouse was awarded the responsibility by the court, any credit information reported by that trade line will impact the consumer's score. If a consumer is an authorized user on an account, despite the fact that he or she has no responsibility for the repayment of the account, any credit reported by a trade line on that account will impact the consumer's credit score. The consumer should have his or her name removed from these accounts. If a consumer has filed or had a bankruptcy discharged prior to October 1, 1997, there may be trade lines on the credit report that were included in the bankruptcy, but are being reported as unpaid collections, charge off, or past dues. While FCRA now requires accurate reporting of these lines subject to penalties for failure to do so, lines reported differently prior to October 1, 1997 must be disputed to be cleared of the inaccurate report. Be sure when clearing or correcting an account that was paid off that the date it was paid off or cleared is accurately reported under the date of last activity column. Otherwise, the appearance of a recent issue will have a negative impact on your score.

Don't Get Frustrated

Every day originators are bombarded with offers on the phone, through our email, on the web and through office presentations about credit repair. Most of these offers come with statements about the capability to remove even accurate derogatory credit items from a consumer's file, or the creation of a whole new credit identity for the consumer. They generally offer to pay you, the originator, in the process. All of these offers are looked at carefully by the FTC and just last year one such credit repair company in Southern California lost a $1.3 million lawsuit to the FTC for false advertising about its capabilities to repair credit. That company and those individuals have been barred from ever participating in the credit repair industry again. These companies are trying to circumvent the rules against charging a consumer for assisting them in repairing their credit by selling their program under the guise of a manual, an educational system or videos, but the message their representatives are putting out the strongest is that they can fix anyone's credit so that they may start over securing new credit.

One company's independent representatives are marketing on the internet and in person all over the country that the company can have bankruptcies, tax liens, collections, and any other derogatory statement removed from a consumer's credit files via legal "loopholes" provided to them in the Fair Credit Reporting Act. They have a 110 percent money back guarantee if the consumer's profile doesn't improve over the one year contract. Many of these independent representatives are even providing as part of their presentation materials copies of consumer credit reports, very marked up to conceal Social Security numbers and account numbers, to provide evidence of their capability to eliminate negative credit. However a company spokesman stated that it cannot remove any piece of credit from a consumer's credit file that isn't outdated, incorrect or unverifiable. "Our company has a zero-tolerance for marketing techniques that indicate otherwise," he said. A bigger fact is that this ability is nothing more than the consumer or the originator, on behalf of the consumer, can do for free if diligent enough.

The biggest issue from our industry's perspective, is concern for the integrity of the information upon which our investors are basing their credit decisions. Just because you can do something does not mean it should be done. Let's assume for argument sake that through enough challenging or reported items in a consumer's credit file with the repositories that one of the trade lines fails to respond to the dispute in the appropriate time, the account is then considered unverifiable and must be removed per the FCRA. It doesn't mean that the information is necessarily gone for good, just until the next reporting cycle for that trade line, but what if that consumer applied for credit during the time the report was "clean"? Now let's consider that the account in question was a recent foreclosure with a bank that no longer exists, no response, "poof" it's gone. That would be a pretty significant fact to omit, certainly one that would violate the originator's reps and warranties in his or her wholesale contract with the investor through which the loan package was closed. We are now talking about ethics and judgment and complicity in fraud. If an originator knowingly has an accurate derogatory item removed from a consumer's credit file, through whatever means and fails to disclose that material fact to the investor using that credit information to base its credit approval on, then the originator, no matter how well intentioned, has just assisted the consumer in perpetrating fraud on a lender, a federal offense. What will happen to our capability to use automated underwriting systems if we can't rely on the credit information on file? Who will pay for the losses incurred by investors or loans made under false pretenses? Will we have little or no down payment loans for long if we have unclear past payment performance by which to asses risk in underwriting a loan? As originators, we are the first line of defense in the risk management process of originating loans. We have a moral and ethical obligation to assist the consumer in understanding their credit profile and making sure it is represented in as accurate fashion as possible. We also owe our wholesalers and investors a duty of care and honesty in how we originate the loans that are submitted to them for funding.

There are compelling reasons to learn about credit scoring from knowledgeable and accurate sources, and to incorporate that knowledge into your daily business practices. The more you understand the concepts behind scoring, the more confidence your consumers will have in your ability to assist them in securing the right loan.