Credit is one of the most critical components in our life, yet the least regulated, and even less understood. More and more, less understood because how you manage your debt affects your credit. Today, credit is measured by a FICO score. It is a snapshot of an individual’s credit at any time.
FICO is a very statistically significant predicative indicator of how well you will repay debt. FICO is an anagram for Fair Issac Company. It is essentially an algorithm for the forty-two variables in your credit report. Depending on what version the repositories use, Equifax (version 96), Transunion (version 98), and Experion (FICO 2 ’98), you will get a different score. The scores range from approximately 300 to 900 points. The higher the score the lower the risk of default. Below 600 the odds are 8-1 you will be 90+ days late on your mortgage payment. Above 800 and the odds are 1299-1 you will be late.
Scores are based on five main types of credit information. Past payment performance, such as late payment, collections, judgments and bankruptcies, past due amount, and tax liens, account for approximately 35 percent of the weight of the score. Credit utilization or the amount of outstanding debt, weighs in at approximately 30 percent of a consumer's score. The length of a consumer’s credit history (how long accounts have been open) accounts for approximately 15% of the score. Inquiries or applications for new credit equal approximately 10 percent of the score. The type of credit (revolving versus finance company accounts etc.) used equals 10 percent. With all these seemingly rigid rules how do you “manage” your credit score?
Well, aside from paying your bills on time, managing your debt correctly is key. The balances on outstanding revolving debt should not exceed 30 percent of the consumer’s available credit limit on a particular credit card. High outstanding balances can have a major negative impact on the score, as they represent higher risk than accounts with lower credit utilization. By paying down, but not closing the account the consumer will improve the percentage of current balances to the potential high credit balance. Paying off revolving debt before installment debt will have a more significant impact on raising the borrower’s score. Please note, however, arbitrarily consolidating credit balances and closing accounts often will have a negative impact on the score as it skews the picture of a consumer’s credit utilization. For instance, your consumer has five credit cards each having a $5,000 high credit limit and four of those cards each have a $1,000 outstanding balance owing. You are using approximately 16% of available credit. Now, you consolidate all of the cards to just one card and close the other cards. Credit surfing for a card with a lower APR? Sounds like a good idea until you do the math and the score goes down. Why would the score go down? You have just done something that artificially skews the percentage of credit utilization from 16 to 80 percent, which obviously represents a higher risk than a consumer using less than 30 percent of available credit.
-written by Michael O’Connor
FICO Scores
FICO® scores were developed by Fair Isaac & Company, Inc. for each of the credit repositories. The scores are: (Equifax) Beacon®, (Experian formerly TRW) Experian/FICO and (TransUnion) Empirica®. They are simply repository scores meaning they only consider the information contained in a person's credit file; they do not consider a persons income, savings or amount of a down payment for a mortgage.
The scores were designed to assess risk. They are useful in directing applications to specific loan programs and to set levels of underwriting, i.e. streamline, traditional or second review. The scores are objective, consistent, accurate and fast.
Many people in the mortgage business are skeptical about the accuracy of FICO scores. Scoring has only been an integral part of the mortgage process in the past few years; however, the scores have been in use since the 1950's by retail merchants, credit card companies, insurance companies and banks for consumer lending. The data from large scoring projects emphasizes the accuracy, the predictive quality of the scores. Large portfolios have been scored for mortgage servicing and investment groups, and again, they demonstrate that FICO scores work.
The scores were developed from each repository's database using actual loan performance. A sample of over 750,000 consumers per repository was used. The repositories have each made great strides to increase the accuracy of their respective database through computer technology and internal monitoring. There is a new standard reporting format for credit grantors to use when sending electronic information to the repositories; this is the critical first step to providing accurate data.
The scores use a multiple scorecard design. Each repository uses 10 individual scorecards, and the models at each repository are the same. This increases accuracy and optimizes the predictive variables for each subpopulation. (For example, a borrower with two 30-day late payments will be scored against a population with some minor delinquencies.) This feature may cause a borrower with delinquencies to score in the same range as a borrower without delinquencies. Scorecards are reviewed and updated every twenty-four months.
The actual scoring process is proprietary, and the algorithms are copyrighted. We can share the predictive variables, the portion of the credit file considered and the weight as provided by Fair Isaac. They are:
- Previous credit performance (35%)
- Trade line information specific to payment history
- Current level of indebtedness (30%)
- Current balance compared to the high credit
- Time credit has been in use (15%)
- Types of credit available (15%)
- Installment loans, revolving accounts, debit accounts
- Pursuit of new credit (less than 5%)
FICO has changed the way it factors credit checks, inquiries. These changes should minimize the "negative" effects that aggressive rate shopping or the normal mortgage process can have on a mortgage applicant. In the new Beacon version, the deduping process has been expanded beyond seven days. One variable counts the number of days within 365 days of scoring. If there has not been an inquiry, the deduping mechanism is not activated. If there is a consumer originated inquiry within the past 365 days from mortgage or auto related industries, these inquiries are ignored for the first 30 calendar days from scoring; then, multiple inquiries within the next 14 days are counted as one. Each inquiry will still appear on the credit report.
Scores should not change significantly because the variable in the model using inquiries contributes less than 5% of the predictive power of the model. According to Equifax statisticians, an average of 5% of the credit reports in the Equifax consumer credit reporting database (over 200 million consumer files) will see a change in score due to this. Fewer than 5% of those will see a change significant enough to effect a loan decision.
In order to get a score a borrower must have the following conditions in his/her file:
- No "Deceased" indicator on the credit file
- At least one undisputed trade line that has been updated in the last six months
- One trade line open at least six months
Scores range from 350 (high risk) to 950 (low risk). A scorecard of 660 will be 660 on Beacon 96, Empirica and Experian/FICO if the data on each file is the same. However, each repository is likely to contain different data.
Every score is accompanied by a maximum of four reason codes. Reason codes identify the most significant reason that a consumer did not score higher. They are not red flags. Consumers with scores in the 800 range get reason codes just as consumers with scores in the 500 range. The reason codes may be used in describing to the consumer the reason for adverse action. Scores are not part of the credit file and are not covered by the Fair Credit Reporting Act. Scores, if disclosed to the consumer, must be related to the credit file - using the reason codes - since the score has no meaning in itself; the meaning or risk level is assigned by the lender and the investor.
When applicants have erroneous information reported, document the inaccuracies. The easiest way to do that is to have your credit-reporting agency upgrade the merged in-file to an edited mid-range report or to a Residential Mortgage Credit Report. With the upgraded report, you can ignore the score! The file will have to be handled in a traditional manner for underwriting and investment purposes. The developed report will provide the paper trail that investors want
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