The FICO score delusion

Mortgage lenders determine a homebuyer’s creditworthiness by using the Fair Isaac Company (FICO) scoring system. A homebuyer’s creditworthiness sets the bar for whether and how much a lender is willing to lend and at what rate.  The FICO score range is from 300-850.

The effects of mortgage inquiries

Two kinds of inquiries exist:

• soft inquiries, which include self-run credit inquiries; and.
• hard inquiries run in connection with applications for credit, including those mortgage loan pre-approvals which entail a credit check.

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

The effects of mortgage delinquencies

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

The effects of a loan modification

A loan modification reduces credit scores, but a pre-established point drop is impossible to determine as the calculation of the ding depends on how the lender decides to report the modification to the credit bureaus. Lenders require a mortgage be delinquent for 60 to 90 days before they will even consider a modification. Thus, by the time a lender has deigned to discuss, much less enter into a modification with a homeowner, the homeowner’s credit score has already been severely damaged by his lender requiring a mortgage delinquency ding as a prerequisite to loan workout discussions.

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.  Here again, the FICO formula presently in place is incapable of differentiating any of these non-foreclosure events from an actual foreclosure sale — they are merely reported to bureaus by lenders as “not paid as agreed.”

The effects of foreclosure

Foreclosures stay on a homeowner’s credit bureau file for seven years, and can negatively impact a score between 85-160 points. However, if a homebuyer keeps his credit clean but for the mortgage default and foreclosure, his credit score will begin to rebound after as little as two years if timely payments are made on his other obligations.  Further, lenders are overlooking these foreclosure-related mortgage issues when a prior owner seeks a home loan after two years if a 20% downpayment is being made.

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, while Chapter 7 bankruptcies stay on file for ten years. The higher the score, the greater the point ding.

FICO scoring as a substitute for responsible lending

The dominance of the FICO score during the Millennium Boom taken in conjunction with the ensuing real estate bust casts a shadow on lenders’ overdependence on FICO scores to predict homebuyer behavior; homebuyers with high credit scores are defaulting in droves because their properties simply are not worth the price they paid. [For more information on the Fed’s discussion of the FICO score, see the May 2009 first tuesday article, Credit after NOD: the lender’s motivation to re-lend.]

Instead of relying on mathematically abstracted number — the FICO score — to set the bar for real estate transactions, the soundest footing for making a real estate loan should again focus on:

• the homebuyer’s gross annual income to set the amount of the fixed rate loan;
• the size of the downpayment as a percentage of the property’s price; and
• the historical valuation approach to demonstrate the property actually qualifies as collateral.

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