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Credit Scores… Important?

Yes, more than ever! “What is his credit score?”  This is one of the first questions that I ask my loan officers when they bring a file to me for review.  “Why?” you ask.  It’s ALL about the credit scores; in fact, it’s all about the middle score of the three credit scores that most people have.  In the lending business the credit score affects interest rate, mortgage insurance (MI) rate, down payment amount, loan type, and, more importantly, whether an applicant is even eligible for the loan.

When I first joined the ranks of mortgage originators, we didn’t have credit scores to help evaluate a borrower’s credit worthiness.  In the “old days” we used the term credit profile, and we had strict rules about the number of revolving lates, installment lates, and mortgage lates.  At that time no one cared about the borrower’s balance-to-limit ratios or length of credit.  With the advent of the use of credit scores by lenders in the mid 90s, however, we had a “dumbing down” of the art of loan origination and underwriting.  Before credit scores we as loan originators would print out the credit report and meticulously go over each line, checking for late payments and looking for bankruptcies and signs of a past foreclosure.  We scrutinized the report for patterns in older late payments, looking for ammunition for the explanations that we knew the underwriter would be demanding.  After we had given due diligence to the file, we then turned it in to the underwriter, hoping that all of that diligence would hold up under his scrutiny.

Then came the advent of the FICO score.  All of a sudden the lates did not matter, as  long as the score was high enough.  Credit scores actually made it easier for borrowers to qualify for home loans.  If the score was 620, the borrower was in; if it was lower than 620, well—too bad; it didn’t matter how the credit profile looked.  Loan officers became slaves to the credit score and, along with the underwriters, we started relying completely on the credit score to determine a borrower’s credit worthiness.  Loan officers became less and less knowledgeable about the true strengths and weaknesses of the borrower, and more and more they became a conveyor belt for loan applications:  Get ‘em in . . . check the score . . . get ‘em out!

What affects your credit score?  What has changed?  What do I need to do as a loan officer?  These are questions that are asked on a daily basis in my office.  They are asked by the clients, and they are asked by our staff.  To understand why, we will first consider how the scores work and then look at some of the changes that Fannie Mae and Freddie Mac have instituted.

First, let’s consider some of the variables that affect your credit score by breaking them down into five categories:

                  • Payment history
                  • Amounts owed
                  • Length of credit history
                  • New credit
                  • Types of credit used

Payment history. Your payment history is the most important variable affecting your credit.  Have you made payments on time?  Do you have any past-due accounts?  Do you have a bankruptcy or judgments?  Positive factors are also considered:  Do you have accounts that have always been paid on time?  How long have you had a good credit history (or bad credit history)?  Lates during the last 6 months have a greater impact than lates that occurred 11-13 months ago.
Amounts owed. The amount that you owe in relationship to your actual credit limit is very important.  Each account is looked at to determine your balance-to-limit ratio.  If the ratio is more than 50 percent, that is a big red flag.  Therefore, you need to keep it at less than 50 percent on each account.  Better yet, keep it at less than 19 percent.  Try to manage your debt:  Just because you pay the balance on a credit card every month does not mean that the zero balance will be reflected in your score, which is actually a snapshot in time.  Your credit card company may report to the credit bureaus at the time your balance is at its highest for the month.  TIP:  Call your credit card company to find out when they report, and then time your payment around that date.  Even if you are not paying the entire balance, you will nonetheless be taking that snapshot at the most favorable time; i.e., your credit score will be viewed in the very best light.

Length of credit history. Do you still have that low-limit, high-rate credit card that you got in college?  DO NOT close that account.  An old account in good standing is one of the best ways to keep your credit scores higher; accounts existing for less than 12 months are considered red flags.  Therefore, keep your old accounts open; if the interest rates are high, don’t charge to those cards.  One surefire way to significantly lower your credit score is to close an old account and transfer its balance to a new card.

New credit. This category goes along with length of credit history, and it also considers additional factors.  An account existing less than 12 months is a red flag; so are accounts existing less than 24 months—just not as much.  There is a “magic number”:  In my experience I have found that the strongest accounts to have are those existing at least 48 months.  Credit inquiries are also red flags that bring scores down.  An inquiry is an alert that a borrower may be trying to access new credit, which can be a sign of instability.  TIP:  It’s okay to shop around.  If you are shopping for a car or a house, multiple credit pulls in a certain period of time (6-14 days, depending on the credit bureau) will count only as one.  So, don’t be afraid to shop around for that car loan.

Types of credit used. It is important to have a good mix of credit types on your report—e.g., two or three revolving national credit cards, a national department store account, a car loan, and a mortgage loan.
Now, let’s consider why lending institutions care so much about scores.  Fannie Mae employs actuaries to study mortgage performance and to determine risk levels for various credit scores, loan amounts, loan to values, document types, property types, and on and on.  In this article we are concentrating on factors that affect the relationship of credit scores and risk level.  Recently Fannie Mae adjusted its automated underwriting engine to better reflect the risk levels associated with mortgage lending.  Fannie Mae’s minimum credit score requirement has been raised to 580—this requirement is a trump card for a mortgage loan.  Even if the borrower is putting down 50 percent and has a million dollars in the bank, Fannie Mae will not take the loan if the middle credit score falls below 580.  As foreclosure proceedings have continued to rise in the past few years, lenders are beginning to take a much closer look at the relationship of credit scores to foreclosure rates.

Fannie Mae and Freddie Mac recently came out with a tiered rate schedule that is determined by the borrower’s credit score.  In the past, whether the credit score was 600 or 800, the rate was the same as long as the automated underwriting system approved the loan.  With the advent of this new scoring system, rates for borrowers with scores below 720 are higher than rates for borrowers with scores above 720.  The system is tiered in 20-point increments all the way down to the newly established low score of 580.  This means that a borrower with a 640 credit score could have a rate that is more than half a percent higher than a borrower with a 730 credit score.

If that were not enough, mortgage insurance (MI) companies have also instituted tier rates based on credit score, and some have refused to issue MI if the score is below 640.  Therefore, even if you have an approval from Fannie Mae’s automated underwriting system, you may not be able to get the MI, which you will need if the borrower is putting down less than 20 percent.  The difference between a 650 score and a 700 score could mean that you MI payment triples!

What does all of this mean to the borrower?  Like it or not, we are going to have to deal with the tightening of these lending standards for the next year or so.  A greater knowledge of how credit works will be the way loan officers set themselves apart from the rest of the crowd.  A great loan officer will be able to counsel a borrower about how to correctly manage his credit scores to maximize his ability to qualify for the best rates, the best MI, and the best loan programs.  Most importantly, a great loan officer can make the difference between the borrower being a renter and the borrower becoming a homeowner.  Loan officers, take heed!  It’s time to be a mortgage professional!

John McClellan
Mortgage Banker
Supreme Lending

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