Learn About Credit

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When a Bank, Direct Lender, or Mortgage Competitor tells you:

“Please do not allow anyone else to run your credit report because it will hurt your score”

Are they telling you the truth, or are they trying to keep you from finding better pricing?

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As you can see from the above clip, directly from Experian, a few inquiries on your credit report as a result of shopping for the best service, price and professionalism, is not a bad thing. Besides that, in almost thirty (30) years of closing mortgage loans, I can’t remember one time that an extra credit Inquire, changed a quote, or stopped me from getting a borrowers loan approved.

The moral to the story is, if someone is trying to scare you away from shopping, they probably have something to hide. I say, follow your instinct’s… If you need to shop, shop!


 

The FICO score

Based on these credit reports, other companies have created proprietary algorithms to analyze the credit performance of consumers. These algorithms calculate a consumer’s credit score. Credit scores allow lenders to standardize credit review and avoid the expenses of a wholly independent staff evaluation of a consumer’s credit history. Simplified, it is an equation which mathematically weighs selected components of a consumer’s credit history and present financial circumstances to arrive at a number- the score- which gauges the consumer’s likelihood of repaying debt.

The most prevalent third-party provider of credit score algorithms is Fair Isaac Corporation (FICO). Fannie Mae and Freddie Mac require the use of FICO scores on loans delivered/sold to them; the Federal Housing Administration also requires the use of FICO scores on loans it will insure. Different FICO algorithms exist, depending on the type of credit requested and the lender’s preference. The Majority of mortgage lenders use a FICO score-based algorithm. [Fannie Mae Single Family/2013 Selling Guide, Part B3-4.1-01, Freddie Mac Single Family Seller/Servicer Guide Chapter 37.5(a)]

FICO’s algorithm signs credit scores in a range from 300 to 850. The higher the credit score, the better the consumer’s access to credit. Likewise the lower the credit score, the worse the consumer’s access to credit.

Lenders use credit scores to measure a consumer’s likelihood of paying (or defaulting) on a mortgage loan, called creditworthiness. Other factors considered in a consumer’s creditworthiness sets the bar for whether and how much a lender is willing to lend and at what rate.

Now, we’ll discuss a generic FICO algorithm as an indication of what makes up a credit score. This information was pulled directly from FICO’s public website and conversations with FICO officials. The actual algorithm used to calculate FICO scores is proprietary, and thus not available for public analysis. Additionally, many lenders use custom FICO score calculations which take into account different factors depending on the lender’s need and credit product (auto loans, mortgage loans). These scores weigh different types of credit and activity differently, and are sometimes referred to as industry scores. The variances across different types of credit scores will be discussed later in the unit.

Establishing a FICO score

Before a FICO score can be established, a consumer must have:

  • one reportable account at least six months old; or
  • one undisputed account which has been reported to FICO in the last six months; and
  • no report on record that the consumer id deceased.

Under the classic FICO score algorithm, only traditional credit accounts are considered. Traditional credit accounts are accounts reported to the credit bureaus such as credit cards, bank accounts and loans. Cell phone accounts, utilities and rental payments are non-traditional credit accounts. Non- traditional credit accounts are not reported to the credit bureaus of considered in the classic FICO score algorithm. So, the classic FICO score calculation does not reflect the positive impact of timely rental payments or utility payments.

However, when such bills are delinquent, they may be reported to the bureaus by those creditors as delinquencies. If the accounts go into collection of become delinquent a judgement is recorded against the consumer, they have an adverse effect on a consumer’s credit score.

Weighing credit history

The classic FICO score is determined based on the following approximate aspects of a consumer’s credit behavior:

  • 35% is based on payment history, including public records such as bankruptcies, judgments and liens, and payment history including delinquencies how severe the delinquencies are, and how long ago the occurred;
  • 30% is based on amounts owed, including the number of accounts with balances, and the proportion of credit lines used or installment loan balances outstanding;
  • 15% is based on length of credit history, including time since an account was opened and time since there was activity on the account;
  • 10% is based on new credit opened, including the number of recently opened accounts in proportion to the existing accounts, the number and timing of recent inquiries and the re-establishment of positive credit history following payment problems; and
  • 10% is based on the type of credit used, including the percentage difference in types of accounts, e.g. credit cards, retail accounts, installment loans, mortgages etc.

FICO provides the scoring formula in a “black box” (meaning the bureaus do not have access to the proprietary algorithm) to the three credit bureaus. The three bureaus in turn subject an individual’s credit history to the encoded formula which determines the credit score. The bureaus then market and sell the resulting scores as a service to lenders (FICO receives a royalty each time a credit score is calculated).

Thus, scores vary across the three bureaus, depending on the debt information each has on a file for an individual. Lenders buying the score then use this information to the extent they wish in their mortgage underwriting decisions. Typically, lenders pull credit scores from all three bureaus then average them or use the middle score to set the score they will consider for use in analyzing the individual seeking a loan.

The impact of derogatory events

On FICO’s consumer website, MyFICO.com, FICO discloses an example of how identified events in a person’s credit profile might affect their credit score, in essence, the numerical extent of the negative credit impact. These numbers are elusive since they are given in a range, and the ranges vary greatly as they are highly dependent on a consumer’s current credit score. However, negative credit events penalize consumers with higher credit scores more than those with lower credit scores.

Data Source: MyFICO.com, the public consumer subsidiary of the Fair Isaac Company (FICO).

  • Uncoordinated multiple inquiries have a greater negative impact than isolated single inquiries. See below for discussion.

^ The drop for loan modification inquiries varies depending on how the lender reports the modification. See below for discussion.

Editor’s note- FICO scores look at a prospective consumer’s entire credit makeup to drive at a FICO score. However, for the purpose of clarification, the discussion of FICO scores which follows treats each event as though all other events remain unchanged, i.e., the impact of foreclosure is only based on that event, and does not include the impact of inherent delinquencies or loan modifications leading up to the foreclosure.

Also, the effect of a negative item on a credit score dissipates over the time after it first appears on the credit report. The credit impact ranges depict the initial impact of each event, not the impact that the even has, say six months or a year later. For more information on this dissipating-impact phenomenon, see “The effects of foreclosure” discussion later in the module. 

Mortgage inquiries

Two kinds of inquiries exist:

  • soft inquiries, which include:
    • self-run credit inquiries;
    • inquiries run by credit card companies when offering promotional credit cards offers; and
    • inquiries run by creditors with whom the prospective consumer has currently relationships, and
  • hard inquiries run in connection with applications for credit, including;
    • mortgage loans (including pre-approvals, or even pre-qualifications which entail a credit check);
    • auto loans; and
    • credit cards

Only hard inquiries drop FICO credit scores, and do so in the range of anywhere from 0 to 8 points.

hard inquiries stay on a FIO score for two years, However, the consumer’s FICO score is based on the number of Inquires in any 12-month period. Important to note is when a consumer applies for a mortgage with multiple lenders within a 45-day period, their credit score will only be negatively impacted for one event. Thus, the FICO score drop 0 to 8 points will only occur once.

Editor’s note- In the 1990’s the FICO algorithm only allowed for a 14-day “Shopping” period, and later a 30-day shopping period. The current FICO algorithm, which went into effect in the early 2000’s allows for a 45-day shopping period. This longer period is more consistent with the Department of Housing and Urban Development (HUD)’s encouragement for consumers to shape several lenders for a mortgage. According to FICO, most lenders who choose to pul credit scores are choosing to pull those using the new algorithm which recognizes a 45-day shopping period, but some may still be using older equations. 

Additional mortgage inquiries made over more than 45 days usually take less than five points off a FICo score. However, this is also dependent on a consumer’s specific credit position. consumers with less credit available (called this credit) and a higher number of inquiries within the 12 month reporting period will experience a grater negative impact for inquiries than those with more available credit and fewer overall inquiries.

FICO’s reasoning is based on research finding that people with six inquiries or more not heir credit report can be up to eight times more likely to declare bankruptcy than people with no inquiries. Inquiries right after delinquencies of defaults also purportedly raise a red flag with the FICO formula, and result in greater credit score drops. Individuals exhibiting these types of activity are classified as high risk and can experience FICO score reductions ranging from 10-24 points per inquiry.

The effects of mortgage delinquencies

30-day mortgage delinquencies, like other credit delinquencies, stay on a consumer’s file for seven years, and might reduce a score between 60-110 points. For 60-day or 90-day delinquencies, the credit reduction migrates to a range closer to that of foreclosure detailed below.

Bothe judgments and accounts in collections cause a drop in credit scores in the range of 85-160 points, to the point drop for a mortgage foreclosure.

In the news: FICO scores and medical collection accounts

Credit giant FICO is releasing their newest credit scoring algorithm into the wild this in the Fall of 2014. This newest iteration, the FICO Score 9, ignores collection accounts when the underlying debt has been paid off, and penalizes medical collection accounts less then other types of collection accounts. The FICO Score algorithm is expected to increase the points of affected borrowers by up to 25 points.

This new algorithm comes right on the heels of May 2014 Consumer Financial Protection Bureau (CFPB) research repot criticizing the treatment of medical collection accounts by the existing credit score models. The CFPB press release outlines credit score improvements which look a lot like those found in the FICO score 9. Good for FICO, good for the CFPB… but is it good for borrowers?

Not really. Lenders have to ado[pt the FICO Score 9 in order for these changes to impact borrowers. Lenders have several credit score algorithms (FICO or otherwise) available to them, and there’s nothing that compels lenders to change their scoring models just because a new one is available. Given the multiple years they were able to collectively drag out the implementation of the new loan disclosure forms, it’s not likely they’ll jump on this credit scoring bandwagon.

The effects of a loan modification

A loan modification reduces credit scores, but a pre-established point drop depends on how the lender reports the modification to the credit bureaus.

Loan modification encouraged by government-sponsored programs was  especially damaging for those seeking help when they were first implemented. In May of 2009, the Consumer Data Industry Association (CDIA) released guidelines encouraging lenders to use comment code “ACwhen reporting loan modifications. Code AC indicates that the account is being paid under a partial or modified payment plan. In FICO score language, this translates into a possible reduction of over 100 points off a credit score.

Editor’s note- CDIA guidelines are not law; their use is optional for lenders when reporting loan modifications.

In November 2009, a new credit scoring comment code of “CN” was added specifically for designating a loan modification was performed under a federal government plan. FICO does not give any wight to this designation as FICO has not yet determined what, if any, predictive power these government loan modifications have on a consumer’s future proclivity to pay their debts.

Editor’s note- This does not mean that a consumer who enters into a loan modification arrangement does not experience credit score impacts. In recent history, lenders often waited until a mortgage was delinquent for 60 to 90 days before they agreed to even consider a modification. Thus, by the time loan modification negotiations have begun, many consumers have already suffered damaged credit scores due to mortgage delinquencies. 

The effects of short sales, deeds-in-lieu and other foreclosure alternatives

Short sales, deeds-in-lieu and other foreclosure alternatives (separate from the loan modifications, as discussed above) are treated similarly to foreclosures when it comes to the corresponding point drop in FICO scores. The classic FICO formula has no way to differentiate any of these non-foreclosure events from an actual foreclosure sale. They are merely reported to bureaus by lenders as “not paid as agreed,” in spite of the fact they have been and are now being paid as agreed under default conditions required by the lender.

Remember: this discussion isolates the impact of each separate credit event. Keep in mind that each consumer will have different credit profile before the foreclosure or foreclosure alternative event. Some consumers will have been delinquent only 60 days when they successfully short sell their properties (and thus discharge the underlying debt). Still other may have been delinquent for an entire year before being foreclosed upon. The change in their credit scores prior to the foreclosure event will create differing impacts upon the event of the foreclosure. The actual single event of the foreclosure or foreclosure alternative, when reported as “not paid as agreed”, is the same, according to FICO.

Now, if the lender chooses to report the foreclosure alternative with designation other than “not paid as agreed”, the impact of the action will be different from a foreclosure. With credit scoring, there is no universal reporting requirement. (Recall that credit reporting itself is entirely voluntary process.)

The effects of foreclosure

Foreclosures stay on a consumer’s file for seven years, and can negatively impact a score between 85-160 points. However, a consumer who makes timely payments on other obligations such as auto loans and credit cards and keeps the use of a additional credit in check can see their credit score rebound after as little as two years.

The effects of bankruptcies

Regardless of the type of bankruptcy petition filed, the reduction in the FICO score is the same- around 130-240 points. Chapter 13 bankruptcies stay on file for seven years, and chapter 7 bankruptcies stay on file for ten years. Bankruptcies do the most damage to FICO scores sine they typically encompass the restricting or charging- off of multiple credit accounts as opposed to one debt on a mortgage loan foreclosure.

Different FCIOs. and educational “FAKO” scores

Even within the FICO system, there are dozens of different credit scoring products, each designed to specialize in determining risk for different types of credit. Additionally, there are versions of each type of FICO score, as FICO updates their algorithms. Lenders are not required to update there systems with each update of FICO algorithm. So, each algorithm will give consumers a different score. And each time the credit score it pulled, the score will likely be different, as even the passage of time will cause credit accounts to mature (a longer credit history is better!) and negatives to fall off.

FICO advertises a consumer educational credit score on their website for consumers. In addition to this FICO score, each of the three bureaus has its own credit score algorithm it uses. Collectively, the three bureaus have also paired up to create the VantageScore, a FICO alternative. In addition, the three bureaus each market their own version of an “educational” credit score. (Colloquially, these non-fido alternative credit scores are referred to as “FAKO” scores.” Just like the numerous FICO scores, these different calculations of credit score will provide different scores, at different times, to the same consumer!

The Dodd-Frank wall Street Reform and Consumer Protection Act tasked the Consumer Financial Protection Bureau (CFPB) with studying the nature, range, and size of variations between these “educational” credit scores and scores used by lenders.

In late 2012, the Consumer Financial Protection Bureau (CFPB) compared credit scoring models used by lenders against those commercially available to the public. The CFPB reviews 200,000 credit files form each of the three bureaus. For all these individuals, the CFPB pulled the generic FICO score, the educational scores marketed by bureaus, the VantageScore, the FICO Auto Loan industry-specific score and the FICO BankCard industry-specific score.

So, did the scores match?

No. But the CFPB found that there was a 90% correlation between scores. That is, the scores gave similar results 90% of the time. Around 78-86% of the time, the distribution of the scores were in the same 10% of the credit scoring range (while FICO runs on a sale of 300-850, while at the time, VantageScore credit scores used a 500-990 scale). Generally speaking educational scores and the different FICO models still land in the general ballpark.

However, loan originators are to take care in advising clients to rely on these non-lender credit score sources. They are general educational tools, and should not be relied on as qualifying information with lenders. This is especially true if the educational credit scores pulled by the applicant are close to the minimum credit scores required by Fannie Mae, Freddie Mac or the FHA.

For the best results when counseling a client, loan originators should focus their energies on the credit report itself. Clients can dispute any errors with the credit bureaus. Documentation about the dispute, and any other negative times on the client’s credit report, can be provided with the loan application. This method will not only provide the lenders’ underwriter with an explanation of negative credit items, but can impact the score the lender ultimately relies on when making a decision on the loan.

As for the educational scores- the CFPB suggested that vendors of these educational scores disclose that the scores are likely different from those a lender will use in determining whether to grant credit. While it is not yet a federal mandate to do so, loan originators can do their part to pass on the information. When discussing credit with clients, inform them of the difference between scores pulled online, and the scores a lender will use.