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Understanding Fico Scores
This article discusses how negative mortgage events can damage a person's Fair Isaac Company (FICO) credit score. We will also discuss the problem of lender over-reliance on scores in calculating credit-worthiness.
A brief overview of the FICO
The Fair Isaac Company (FICO) score is the most popular tool currently used by lenders to estimate a homebuyer's likelihood of paying (or defaulting) on a mortgage loan. The result is usually referred to as "creditworthiness." The creditworthiness of the home buyer (along with other indicators such as employment history, assets held, etc, etc) helps the lender to decide the amount they are willing to loan and at what rate.
The FICO score was developed to provide an out-sourced, standard benchmark to calculate credit. It also helps in avoiding the costly expenditure associated with an independent staff evaluation of a homebuyer's credit history. Put simply, it weights certain parts of a homebuyer's credit history and current financial situation and uses a formula to calculate a score. This score represents the likelihood the homeowner can repay the loan.
Prior to a FICO score being determined, a homeowner must have:
- One reportable account (bank account, loan, credit card, etc) at least six months old or
- One reportable account which has been reported to FICO in the last 6 months and; and
- No report on record that the homeowner is deceased
Notes on how regular utility bills effect your FICO score - A homebuyer is not awarded points for making payments of rent, utilities or cell-phone bills on time. They are penalized if they fail to pay these obligations. FICO scores do not include a homebuyer's history of paying these bills and on their own they're not enough to calculate a FICO score.
However, if these payments enter arrears they may be reported to the relevant bureaus by the creditors as being in arrears. If the accounts enter collections or become so past-due a judgment is made against the home-buyer, they can have a negative effect on the homebuyer's credit score.
This is not to say that timely utility bill payment history does not help you in the home buying process. Your utility bills are just one component of many the bank will consider. If you lack credit history, submitting proof of timely utility and rent payment will help you get a loan.
Once the six-month eligibility period has passed, the homebuyer's credit behavior is assessed again and a score is awarded based on what FICO knows about the buyer's credit behavior. The FICO score ranges from 300-850. In theory, a higher score represents that the homebuyer is more likely to repay his liabilities. However, as the credit score is based on a history of credit use, if the buyer has never been in debt (or had credit) the score will be zero.
A FICO score contains 5 components calculated from debts reported to FICO, weighted as below:
- 35% is payment history, including public records such as bankruptcies, judgments and liens and payment history including arrears, the length of the arrears and when they occurred;
- 30% is amounts owed, including the number of accounts with balances, and the ratio of credit available used or installment loans outstanding;
- 15% is length of credit history, including how long the account has been opened and active;
- 10% is new credit established, including the ratio of new accounts opened to existing accounts. The amount and timing of recent inquiries and the re-establishment of positive credit history after payment problems; and
- 10% is type of credit use, including the percentage difference in types of accounts, e.g. credit cards, installment loans, mortgages, etc.
FICO provides the formula for score calculation in a "black box" (which means the bureaus cannot access the proprietary algorithm) to the three credit bureaus - Experian, Transunion and Equifax. Subsequently the three bureaus enter a person's credit history into the ciphered formula which then calculates a credit score. The bureau then markets and sells these scores as a service to lenders. (A royalty is paid to FICO once a credit score is determined).
Due to the level of debt information each bureaus possesses, the scores will vary among them. Lenders will buy these scores and use to them to determine mortgage underwriting decisions. Usually, lenders will obtain credit scores from all three bureaus and use an average or mean to evaluate an individual applying for a loan.
The Media often exaggerates the damage to a FICO score when a homeowner decides to walk away and the other negative financial aspects of the Great Recession, the inclusive housing bust and the resulting financial crises. Many commentators predict a decrease of 200-300 points for a foreclosure. Self-proclaimed "Experts" enter the fray to discuss how a homeowner's credit is affected when facing foreclosure or thinking about using their enforceable walkaway option.
The multitude of opinions from the unqualified confuses homebuyers and keeps them in the dark - a reprehensible action that has been termed "asymmetry of information". This describes when the buyer does not have full knowledge of information that would affect his mortgage decision. Therefore, it is the responsibility of brokers and agents to assist prospective homebuyers and sellers sort through the contradictory information and to have enough knowledge to undertake housing and mortgage decisions. This is all part of a licensee's duty to their client.
On FICO's consumer website, MYFICO.com, FICO illustrates how certain events in an individual's credit profile could affect their score and shows the cash value of the resultant credit decrease. The figures are not exact as a range is used and these ranges vary a lot due to being based on a homebuyer's current credit score. This makes FICO's scoring method slightly inaccurate as it punishes homebuyer's with good credit scores more than those who already have lower scores from past transgressions.
FICO scores are calculated by considering a potential homebuyer's complete credit makeup. However, to make things easier the following discussion of FICO scores treats each event in isolation, i.e. the effect of foreclosure is only based on that event, and does not include any delinquencies or loan amendments preceding the foreclosure. This allows the best picture available to those looking to resolve their mortgage difficulties.
Also, the effect of a negative item on the mortgage score decreases from the time it was initially registered. The initial impact of the event is shown, not the effect it has six months or a year after.
For more information on "The decreasing-impact" phenomenon see the discussion below.
Mortgage Inquiry Effects
There are two types of inquiries:
Soft Inquiries which include:
- Self-initiated credit inquiries;
- Credit-card initiated inquiries when offering promotional credit card offers; and
- Creditor Inquiries who the prospective home purchaser has a current relationship with; and
Hard Inquiries performed in connection with applications for credit, including:
- Mortgage loans (including pre-approvals, or even pre-qualifications which necessitate a credit-check)
- Auto loans; and
- Credit Cards.
Only hard inquiries decrease credit scores and only in the range of 0 - 8 points.
Hard Inquiries are recorded on a credit score for 2 years. However, the home purchaser's credit score is calculated by the number of inquiries in any 1 year period. It's important to be aware that when a home purchaser applies for a mortgage with multiple lenders within a 45 day timeframe, their credit score will only be "Charged" -negatively affected - for one event and therefore the FICO score decrease of 0 to 8 points will only happen once.
Notes on Shopping Period - In the 1990s, the FICO algorithm only permitted a 14-day "shopping" period, and later a "30 day" shopping period. The latest version which started to be used in the early 2000s permits a 45-day shopping period. Some might still be following the older version, and therefore give home purchasers less time to finish loan applications before reporting a new, different inquiry (and the subsequent 0 - 8 point negative credit impact).
Mortgage inquiries completed over a longer timeframe or outside of the 45 day multiple loan application timeframe often reduce the credit score by less than 5 points.
However, this is also reliant on a home purchaser's specific credit position. Purchasers who have less credit available (called "Thin credit") and a higher incidence of inquiries over the past 12 month reporting timeframe will experience an undetermined but greater negative effect for inquiries than those with more available credit and fewer overall inquiries. This represents a reverse order of weighting on the credit score than FICO applies for foreclosure related events.
FICO bases it's reasoning on research which found that people with 6 or more inquiries on their credit report can be as much as 8 times more likely to declare bankruptcy than people without any inquiries. Inquiries immediately following delinquencies or defaults are also said to be a bad sign with the FICO formula, and result in undisclosed greater point decreases to the credit score. People who show this type of behavior are categorized as "High Risk" and can experience FICO score decreases between 10 - 24 points per inquiry.
Mortgage Delinquency Effects
30-day Mortgage delinquencies, in common with other credit delinquencies, remain on a homeowner's file for 7 years, and might decrease a score anywhere from 60-100 points. For 60-day or 90-day delinquencies, the credit score decrease moves closer to a range associated with foreclosure (described below).
Unusually, on-time rental and utility payments are not counted as pluses in the FICO score calculation. However, late payments on either rent or utilities may be reported to credit bureaus (at the discretion of the landlord and utility company). Then are then recorded as delinquencies and subsequently cause a decrease in the FICO score. Landlords or utility companies can also get judgments for late payments, or send the payment account to collections agencies. Judgments and accounts with collection services both cause a decrease in credit from around 85-160 points, very similar to the point decrease awarded a mortgage foreclosure.
Loan Modification Effects
A loan modification decreases credit scores, but it is impossible to calculate the decrease in advance as it depends how the lender reports the modification to the credit bureau.
Loan modifications encouraged by government-sponsored programs were particularly detrimental to people looking for help when they were first implemented. In May 2009, the Consumer Data Industry Association (CDIA) released guidelines telling lenders to use comment code "AC" if reporting loan modifications. Code "AC" indicates that a partial or modified payment plan is being used to pay the account. In FICO score terminology, this translates into a possible decrease of over 100 points from a credit score.
Notes on CDIA Guidelines - CDIA guidelines have no legal base; their application is optional for lenders when reporting loan modifications.
In November of 2009, a new comment code for loan modifications was added. This code - "CN" specifically indicates that a loan modification was undertaken as part of a federal government plan. As yet, FICO does not include the designation in it's weighting calculation. It has not determined how these government loan modifications will affect the likelihood the homeowner will continue to pay their debts. Loan modification programs are not successful with approximately 65% of modification recipients re-defaulting following permanent modification (with few initial modifications turning into permanent ones). As a result, the "CN" code for modifications will be short-lived.
Notes on Loan Modifications - This does not mean that a homeowner who undertakes a loan modification agreement will not experience an effect on their credit score. Lenders require a mortgage be past-due for 60-90 days before they will think about a modification. Therefore, by the time a lender has decided to enter into negotiations with the homeowner about a possible modification, the homeowner's credit score has already been negatively affected by the lender requiring a mortgage delinquency be recorded.
The impact of short sales, deeds-in-lieu and other foreclosure alternatives
Separate from the previously discussed loan modifications, short-sales, debts-in-lieu and other foreclosure alternatives are treated almost the same as foreclosures when it comes to calculating the decrease in FICO scores. Today, the FICO calculation cannot separate any of these non-foreclosure events from an actual foreclosure sale. They are just reported to bureaus by lenders as "not paid as agreed", despite continuing to be paid under default conditions as required by the lender.
Therefore, a struggling homeowner contemplating their options and worried for their FICO score does not need to be excessively concerned. Whether they try a short sale or other workaround with their lender or simply release their claim to the property by way of foreclosure, the negative impact on the FICO score will be equal.
Of great importance to defaulting homeowners for future consideration is that lenders must lend to stay in business. Therefore, a negative equity homeowner that purposefully arranges his future credit needs before deliberately (strategically) defaulting on their mortgage and vacating the property at the time of foreclosure sale will not be penalized by a severe hit to their credit score for their rational behavior in walking away.
Also, Fannie Mae has recently announced it is willing to lend to homebuyers within two years of a short sale or deed in lieu arrangement, an event which softens the blow to the credit score.
The Impact of Foreclosure
Foreclosures remain on a homeowner's record for 7 years and can negatively affect a score by 85 - 160 points. However, if all over lines of credit are kept clean apart from the mortgage default and foreclosure (which usually happens in a strategic default) the credit score will begin to recover in as little as 2 years if their other liabilities (such as auto loans and credit cards) payments are made on-time and they keep their use of additional credit under control. The lender will then be eligible for a Federal Housing Authority (FHA) insured mortgage, which is available 2 - 3 years after a foreclosure.
The Impact of Bankruptcies
The reduction in the FICO score will be between 130 - 240 points - no matter what type of bankruptcy is filed. Chapter 13 Bankruptcies stay on record for seven years, whilst Chapter 7 bankruptcies remain for ten years.
Bankruptcies have the largest impact on FICO scores as they usually result in the re-structuring or charging-off of multiple credit accounts as opposed to just a mortgage loan foreclosure. From the homeowner's vantage point, there is no requirement for a federal bankruptcy petition if the home is the only debt they want to discharge. Bankruptcy would cause a far more detrimental effect than necessary since disclosure would discharge the purchase-assisted home in accordance with California Law.
As long as the homebuyer keeps their credit under control, the FHA is willing to insure a mortgage within two to three years of the declared bankruptcy.
The Asymmetry of Information
The FICO score was derived to allow lenders to outsource a lot of the work that provides the background for their loan decisions. The FICO calculation does much of the hard graft for lenders and employees don't have to find out and consider each individual homebuyer's credit worthiness. Unfortunately, as the industry began to depend on these scores too much potential homebuyers (and other lenders) began to get wise to the system.
As FICO was a proprietary formula developed for the bureaus (and therefore for constituent lenders), many components of the FICO scoring system are deliberately kept secret. This keeps homeowners in the dark and unable to make educated decisions about defaulting on their loan because they don't know the likely consequences. The fact that these undisclosed conditions exist is highly surprising given the effect that have on a potential home buyer's financial future. The fate of a homebuyer's finances is in effect tried in private, with the credit score acting as the secret judge and the lenders the juries.
FICO is not regulated by the Government as it is a private company. Its only role is to provide a "Predictive" scoring system to bureaus and then subsequently the lenders. These two parties will then make financial decisions which affect all areas of consumer borrowing and a result - the national economy, including the nation's housing policies. An inordinate amount of a prospective home purchaser's financial data is placed under scrutiny by a patently misused and defective formula, three credit bureaus and the nation's creditors - as they report - incorrectly or not - a person's financial situation.
The potential lender must then obtain their credit report (which is free annually, but payment is required to see the actual score), check for erroneous items on the report and ask the creditor (or lender) to re-report them correctly.
After this process has been completed, the homeowner must pay again if they want to see their actual credit score. This is the case despite the lender being the party which benefits most from having the credit score as they don't have to perform an independent analysis of the homeowner's creditworthiness.
After FICO gives these figures to the lenders, the lenders still have the fate of the homeowner in their hands. Lenders create internal criteria based on FICO score ranges. Several iterations of the FICO score are available to lenders. The lenders can decide what will be more convenient in assessing their borrower base. Therefore, lenders can decide upon how to calculate the FICO score.
A lender is also free to decide just how it reports the borrower's behavior. As covered earlier, these reporting decisions can cover how a lender decides to report an inquiry, how they report a loan modification, or how they correctly or incorrectly report a borrower's payment history. Regardless if the event is reported correctly or not, the lenders can influence how the same event impacts on the credit score.
Therefore, homeowners possess imperfect knowledge about their financial situation while lenders are free to act in their own best interest and protect their bottom lines.
FICO Scoring in Lieu of Responsible Lending
The effectiveness of the FICO score was tarnished during the Millennium Boom and the subsequent real-estate bust. Many home buyers with high FICO scores are defaulting because their houses have lost value since they purchased them. A rational homebuyer acts in their own best interests, regardless of what the credit score is telling them.
FICO itself even delivered a report on the change in profile of defaults across credit score ratings. The report lays out that in 2005 homebuyers in the Western US (including California) with high FICO scores (760-850) were 6.4 times likelier to default on their credit cards as opposed to their mortgages. In 2009 this ratio had decreased to just 1.3. Therefore, homeowners were becoming wiser as to how they were being measured and began reacting more rationally.
Notes on Vantagescore - Each of the three credit bureaus - Experian, Transunion and Equifax - employ a version of the FICO scoring calculation to report credit scores. In 2006, the three credit bureaus devised their own credit scoring calculation, the Vantagescore, so they could stop being dependent on the FICO model. So far, Vantagescore has seldom been used in the industry as it does not possess enough historical data to assure most lenders of its reliability. The end result is that FICO has to deal with two uncertainties; reliability and competition.
The lenders ability to manipulate the borrower's credit history by various different ways of reporting provides lenders with yet another asymmetrical advantage over a homebuyer. This is especially true as the borrower is not provided with the undisclosed information the industry has kept from them to make a decision. These vital components include delinquency, negative equity or foreclosure.
Despite the type of credit score employed, the previous trend of calculating a lending decision based on a credit score without fully considering a borrower's information (as the popularity of low-doc/no-doc loans during the Millennium Boom illustrates) has been shown to be irrefutably unsuccessful. Instead of relying on a single figure - the FICO score - to benchmark real estate transactions, a more logical method for deciding whether to make a real estate loan should employ:
- The borrowers gross annual income to calculate the amount of the fixed loan rate;
- The amount of the down payment as a percentage of the property's price; and
- The historical valuation data that proves the property qualifies as collateral By relying on a credit score alone the playing field for lender to lender will not be level if these conditions and other individual factors are not given the correct weighting.
In a few years time, when the homeowners who vacated their unaffordable mortgages start to apply for mortgages again, lenders will no doubt see numerous letters of explanation detailing the necessity of making a rational decision to walk away. Lenders will be dependent on these errant homeowners to again apply for mortgages so they can remain in the money lending business. The letters of explanation will provide witness to the fallacy of depending on an ill-regulated, abstract mathematical calculation rather than more logical lending criteria. This better educated lender will be able to produce higher returns on their loan portfolio yields and the borrower will finally have the transparency required to make informed, long-term financial decisions.
In conclusion, it is a warning to those controlling credit scores that although transparency might not be in the bureaus and lenders best interests not having it could lead to stricter and more rigorous regulations being enforced which could finish the credit scoring process once and for all.
Links to Useful Credit Report Information:
You can visit the Federal Trade Commission's "Facts for Consumers" page to find out how to obtain your free credit report and correct erroneous submissions.
Contact FICO to purchase the credit score itself. You can also contact any of these three credit bureaus - Experian, Transunion or Equifax, though it must be remembered that scores could different due to their different treatment of credit history events. Single-bureau scores cost around $15, while purchasing all three costs around $40. All self-run inquiries are soft inquiries so don't worry about them affecting your credit score.
Furthermore, all three bureaus and some third-party organizations provide services that track a borrower's credit score for a monthly fee. These services can be useful to protect against identify theft and to analyze how the credit score changes in relation to credit use.