Automated underwriting and credit scoring now rule over almost all of the mortgage loan approval and pricing process. Instead of an individual underwriter carefully reviewing dozens of a borrower's financial documents to arrive at a credit decision, mortgage applicants are first sorted based on the credit score contained in their credit report. Now, many lenders will only consider a borrower for a specific mortgage loan program if their credit score exceeds a minimum requirement.
In 2011, credit score requirements are now much higher than before the mortgage credit crisis of the past three years. Usually, the better your credit score, the less down payment you need on a purchase and the more equity you can borrow against for a refinance. For example, a borrower with a 620 credit score or higher who can document his or her income can borrow up to 97.5% of the value of the property on a purchase through the FHA program (at least for now - see below). Borrowers with credit scores below 620 will have to put down anywhere from 3.5% to 10%. Only a few lenders will approve loans with scores below 580 and only through the FHA program as of 2011, but those borrowers will usually have to go through an exhaustive manual underwriting process to get approved.
While credit scoring can speed up the approval process for perfectly qualified borrowers, many borrowers with recent or past credit problems may find themselves closed out of the mortgage market. For example, a borrower requesting a loan for $100,000 to purchase a $200,000 home who has $500,000 in assets and a steady job making $100,000 per year would normally be easily approved as long as his or her credit history met minimum standards. Under the new system, even that otherwise perfect borrower would not be approved for a loan if his or her single number credit score was below the required threshold.
A borrower with a high credit score will be able to qualify for a loan today and will get a slightly better mortgage interest rate. For example, borrowers with a credit score above 720 can either get a mortgage up to 95% of the value of a home or their rate can be an 1/8% lower than borrowers with lower scores.
Credit scoring is not a new concept. Since the 1950's lenders have attempted to develop a single objective number to evaluate and compare consumer's willingness and ability to repay a loan. Credit scoring has been the main method for credit card issuers to approve card holders for new cards and credit line increases in seconds.
The credit scoring concept is based on boiling down a borrower's entire credit history into one objective number. To help borrowers understand where they might score when they apply for a mortgage, the Mortgage Almanac researched exactly how credit reporting companies come up with scores for borrowers.
Credit scoring systems analyze and combine five key factors to obtain a single credit score. The most important factor, of course, is a borrower's record of paying their debts. Primary emphasis is placed on the last two years of payment history on currently outstanding debts. Thus, one 30 day late payment on a credit card or car loan within the six months prior to a credit scoring date could reduce a total score much more than four late payments four years earlier.
Combined with payment histories, collection accounts and public records are also factored into a borrower's credit score. Medical bills that go to collection, bankruptcies and lawsuit judgments all drag down total scores. Surprisingly, a bankruptcy does not automatically bring a credit score down. Mortgage professionals report numerous instances of borrowers with past bankruptcies on their credit report earning better credit scores than borrowers without one. Borrowers who establish new credit after a bankruptcy and maintain an excellent credit history afterward for at least two to three years can often achieve acceptable credit scores.
Credit scoring systems also look at the number of inquiries to a borrower's credit report over the last six to twelve months. A large number of inquiries can indicate that a borrower has been making an effort to obtain too much new credit too quickly. Consumers must be careful when preparing to apply for a mortgage to limit credit applications to other credit grantors. Sometimes this can be harder than it seems. For example, many borrowers who apply for a car loan at an auto dealership actually have their credit run three or four times-first by the dealership and then by two or three lenders that the dealer sends the loan in to be approved.
Another credit scoring factor is a borrower's outstanding balances against available credit limits. A borrower with $9,995 borrowed on credit cards with $10,000 in credit limits will be severely penalized by all credit scoring systems even with a perfect payment history. The rationale for lenders is that a borrower at maximum credit limits has no room to handle any emergencies that may arise. The only problem with this theory is that a borrower may have $100,000 in a bank account to handle problems that arise but credit scoring does not take this into account.
Thus, in the new credit scoring system, having several credit cards with low balances in relation total credit limits results in a more favorable rating than having one credit card with a high balance. This is true even if a borrower owes exactly the same amount of money. The irony here is that ten years ago exactly the opposite case was preferred by lenders. Until the 1980s, lenders would worry that a borrower with high unused credit limits would run up their credit cards right after buying a house and have too much debt. Many mortgage lenders would require borrowers to close credit cards with high credit limits prior to closing on their mortgage.
The last consideration of most credit scoring systems is how long open accounts have been open. The longer that a revolving account has been open, the better. Unfortunately, recent college graduates and new immigrants are two categories of borrowers who might not have long credit histories. Under the new credit scoring regime, these individuals may find it more difficult to obtain a mortgage. The good news for borrowers with limited credit histories is that new alternative credit programs have arisen that permit borrowers to use utility bills and other accounts that do not show up on a credit report to prove their credit history.
Partly due to federal anti-discrimination laws, and partly due to their irrelevance in the credit process, factors such as age, national origin, race, marital status, gender and religion are not taken into account. One positive aspect of credit scoring is that groups that have traditionally suffered from mortgage discrimination will benefit from an objective comparison system.
Recent studies claim to show that credit scoring systems are predictive across both income levels all other factors According to Freddie Mac studies, loans for borrowers with FICO scores greater than 660 performed better than loans for borrowers with FICO scores between 620 and 660, controlling for all other factors. And loans with scores from 620 to 660 performed better than loans for borrowers with FICO scores below 620.
If you need to improve your credit score, the first step is to get a real secured Visa card. You get a card for a credit line equal to the amount you deposit in the bank that gives you the card. Make sure the secured visa you get is not just a pre-paid debit card because that will not build your credit.
Similarly, despite concerns to the contrary, a review by Freddie Mac shows that borrowers making less than 80 percent of area median income were only slightly more likely to have high-risk credit scores than borrowers making more than 120 percent of area median income.
Since all studies appear to show that the credit scoring systems accurately predict whether a borrower should be approved for a mortgage loan, both Fannie Mae and Freddie Mac (the two institutions that purchase most mortgage loans nationwide) have adopted credit scoring guidelines for lenders who sell loans to these agencies. While 620 used to be considered an acceptable credit score for Fannie Mae and Freddie Mac, 680 is now considered the minimum score to have acceptable credit for their programs. Those between 620 and 680 in the current market will have to look to the FHA program for a mortgage unless they are making a down payment of at least 20%.
Fannie Mae and Freddie Mac used to offer mortgages to borrowers with credit scores below 620 but most of those programs are gone.
With credit scoring impacting borrower applications so strongly, making sure one's credit report is accurate becomes more critical than ever. In the past, a borrower could simply obtain documentation to show that an account was not late or did not belong to the borrower and include it in the application to obtain approval. Today, if that information brings a borrower's credit score below 620, even if it is not correct, the borrower is stuck until the information can be removed from their credit reports and the report can be scored again. The good news is that many credit reporting agencies used by mortgage lenders can now offer error corrections within a few days instead of the weeks and months that it used to take.
If all incorrect information has been removed from a report and the credit score is still below 620, the borrower will need to work on improving their credit history over an extended period of time (See article on Strategies for Boosting Your Credit Score). This process could take anywhere from one month to three years depending on the severity of the problem. The good news is that once borrowers reach 620 or higher, they will immediately become eligible to be approved for almost all mortgage loan programs.
Borrowers who need to buy a home immediately and can not wait for their credit scores to improve are left with only two options. One options is to search for one of the dwindling number of mortgage lenders who are not using credit scoring to evaluate borrowers. Portfolio lenders will be most likely to be the longest holdouts in adopting scoring systems. The other option is to move to what is called the "Sub-prime" mortgage markets, where borrowers with poor credit histories can obtain mortgage loans at higher interest rates.
Finally, there is some good news for borrowers with the best credit scores. Many lenders are now offering borrowers the chance to save 1/8 or 1/4 of a point off the points for a fixed rate loan. For a $200,000 loan, this savings can translate into $250 to $500 at closing. Borrowers should inquire if their lender has started a similar program when submitting an application.
Michael Licamele is Editor of MortgageAlmanac.com
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