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A MORTGAGE LENDER CONSIDERS four categories of risk when making a real estate loan. These are sometimes called the four Cs.
- Credit is the borrower’s likelihood to make regular on-time payments.
- Capacity is the borrower’s ability to pay based on their income and long-term debt.
- Collateral is the real estate which secures the loan.
- Capital is the down payment.
This article focuses on the subject of credit, which has until recently been the most difficult part of the home loan process for consumers to understand and control.
California’s Credit Disclosure Law
On July 1, 2001 a new California law went into effect giving consumers access to their credit scores. In addition to the score itself, SB 1607 requires credit scoring companies to provide meaningful information about how the score is created. The new law allows borrowers to collect damages from creditors and credit reporting agencies if they don’t correct errors in a timely manner. California, a leader in consumer rights legislation, was the first state to pass a credit disclosure law. Federal credit disclosure legislation is currently working its way through congress.
Until recently, credit scores were a closely-guarded secret. The three largest credit file repositories in the nation – Experian (formerly TRW), Equifax and Trans Union – maintain huge databases on the paying habits of borrowers throughout the country. Their data is based on voluntary monthly reports submitted by banks, mortgage lenders, department stores, credit card companies and others.
For years the credit file repositories claimed the scoring process was too complex for borrowers to understand. They were also concerned that people might attempt to beat the system if they knew too much about how their scores were developed. Consumers complained that their credit information was often full of errors and that credit reporting agencies had no incentive to correct them. Some of these errors led to lower credit scores which cost individual borrowers tens of thousands of dollars in higher interest rates and loan fees.
Some unscrupulous lenders were deliberately not reporting the good paying habits of their borrowers to prevent their competitors from luring them away with lower interest rates. Predatory lenders were steering elderly, low-income and minority borrowers into higher interest loans when their credit scores would have qualified them for cheaper rates.
In February, 2000, on-line lender E-Loan challenged the system by letting consumers view their credit scores for free. Soon after, Equifax cut off E-Loan’s access to the scores. Consumers were outraged. The credit industry, realizing it had made a public relations blunder, relented and began allowing consumers to see their scores. But the damage was done and the push began for credit disclosure legislation.
Credit Scoring
Credit scoring has replaced the old fashioned face-to-face meeting with the loan officer, who had to make a personal judgment about the character and credit risk of the borrower. While some individuals have exceptional talent for making these types of complex intuitive decisions, people are a lot slower than computers and some human minds are clouded by prejudice. Computerized credit scoring is faster and cheaper and blind to gender, race and ethnic background.
With powerful computers, sophisticated software and lots of personal data about almost everyone, it’s becoming easier to predict human behavior with remarkable accuracy. Insurers are using computer-generated scores to set car and home insurance premiums. Health care providers use a scoring system to determine who gets billed and who has to pay at the doctor’s office. The IRS uses scores to decide who to audit. Computerized risk management systems can detect patterns that predict everything from future health problems to criminal behavior.
The FICO Score
Credit scoring was invented in the 1950s by two Stanford University researchers – engineer Bill Fair and mathematician Earl Isaac. Fair, Isaac & Company’s FICO score is now the most widely used credit bureau score in the world. Automated FICO scores were introduced around 1989. In 1995 Fannie Mae and Freddie Mac, the two secondary mortgage market giants, began recommending that lenders pull credit scores for all borrowers. FICO scores are also used by credit card companies, department stores, automobile lenders, employers, landlords and insurance companies.
The computerized FICO scoring model is based on a statistical analysis of the credit history of millions of borrowers and has become a highly accurate predictor of credit risk. The data that goes into producing the score has been mostly revealed, but the way the numbers are crunched is a well-guarded secret. The FICO score predicts your likelihood of repaying a loan without late payments (delinquencies) or nonpayment (default). FICO scores do not consider the following.
- income
- job stability
- length of time in the community
- future prospects
- gender
- race
- ethnic background
FICO scores do consider the following.
- creditors
- account types, dates and status
- last activity
- credit limits
- account balances
- maxed out balances
- credit inquiries
- tax liens
- judgments
- bankruptcies
Late payments stay on the records for two years while bankruptcies stay on the records for ten years. Mortgage lenders make loans which are secured by real estate, so your credit score is only part of their lending decision. However, your credit score is the only thing which qualifies you for unsecured loans such as credit cards. Your score determines your credit card interest rate and credit limit.
Prior to writing this article, I logged onto www.myfico.com and paid $12.95 for my credit score. Within minutes I got a 4-page FICO score analysis and an 8-page credit profile report. I learned that my score was 789 within a possible scoring range of 300 to 850. The score was generated by Equifax. If I had checked my score from Experian or Trans Union I would have probably gotten two different numbers. Most lenders use the median or middle score.
A couple of charts showed me I had a lot of company – 29 percent of all FICO scores (the largest group) fall within the 750-799 range, which has a 2 percent delinquency rate. Eleven percent of the scores are above 800, with a delinquency rate of only 1 percent. At the other end of the chart, only one percent of FICO scores were below 500, but their delinquency rate was a whopping 87 percent.
My 8-page credit profile went all the way back to a Chevron card I got in 1973 and a mortgage I took out in 1976. The score analysis gave me the reasons why my score was not higher as well as some tips for improving it. They listed the phone numbers and e-mail addresses of Equifax, Experian and Trans Union for reporting any errors.
Risk-Based Pricing
For years, lenders have been classifying loans by the borrower’s credit worthiness from best to worst as A, B, C and D. With the widespread use of credit scoring, these categories have less meaning now but are still in use. The A category of loans is designed for borrowers with FICO scores above 620. The other loans are called sub-prime. Through a system of risk-based loan pricing, many people are now getting home loans who might have been rejected in the past.
Borrowers in the prime category get the best mortgage interest rates and can make down payments as low as 5 percent. Borrowers with scores above 680 or so are eligible for quick qualifier or low documentation loans. Borrowers with the highest scores may get an interest rate a half a percentage point lower than the going rate for a fixed conventional 30-year mortgage. The actual cut-off points vary slightly from one lender to the next.
Unlike A-rated loans, all sub-prime loans require more documentation and cautious manual review. B loans may charge 1 to 3 percent more interest than A-rated loans and require a down payment of 10 to 25 percent. C loans may charge 3 to 6 percent more interest than A-rated loans and require a down payment of 20 to 50 percent. The highest risk D loans may charge 7 to 12 percent more interest than A-rated loans and require a down payment of 50 percent. The actual rates and down payments depend on the lender’s guidelines, the type and value of the property serving as collateral and the income and debt ratios of the borrower.
Before 1990, sub-prime borrowers made up about 20 percent of the U.S. population. By the year 2000, the sub-prime population had risen to about 35 percent. According to “Consumer Reports,” the volume of sub-prime mortgage loans increased ten-fold between 1994 and 1999, to $370 billion. Maxed out credit cards, job layoffs, divorce or illness can easily bump a borrower into the sub-prime area. Because sub-prime borrowers pay higher interest rates and loan fees than prime borrowers, many lenders have been drawn into this lucrative market. Sub-prime borrowers need to be alert and well-informed, however, because they are sometimes prey to abusive and predatory lending practices.
Buying With Problem Credit
If you want to buy a home but have credit problems, there are several things you can do.
- Get your credit report from all three credit file repositories (Experian, Equifax and Trans Union) and correct any errors.
- Contact a credit counselor such as Consumer Credit Counseling Services (www.cccsintl.org) for advice on improving your credit.
- Avoid credit repair scams, which are seldom helpful and may even be illegal.
- Ask the seller to finance the mortgage.
- Assume an existing mortgage.
- Lease with an option to buy.
- Get a loan from a sub-prime lender (be sure you don’t qualify for a prime loan).
- Get a loan from a portfolio lender (a lender that does not sell the mortgage on the secondary market and who can be more flexible).
- Get a loan from a hard money lender (a lender that obtains money from private investors).
- Shop around but be alert for abusive and predatory lenders.
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Chet Boddy, Real Estate Appraisal, Sales and Consulting
43300 LR Airport Road, #59, Little River, CA 95456
707-937-4011, office
707-937-4818, fax
chet@chetboddy.com
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Copyright © 2002 Chet Boddy, All Rights Reserved
Chet Boddy is a Certified General Real Estate Appraiser, Realtor“ and real estate consultant who has lived on the Mendocino Coast since 1976. Look for this and other real estate columns on Chet’s web site at www.chetboddy.com
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