This article discusses the impact negative mortgage events have on an individual’s Fair Isaac Company (FICO) credit score, and discusses the harm of lender over-reliance on scores in determining creditworthiness.

A brief overview of the FICO

The Fair Isaac Company (FICO) score is the predominant tool presently used by lenders to determine a homebuyer’s likelihood of paying (or defaulting) on a mortgage loan, a measure referred to as creditworthiness. Along with other factors considered in a loan application (such as job history, cash reserves, etc.), 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 was developed so lenders could defer to an out-sourced standard to determine credit and avoid the expense and vicissitudes of an independent staff evaluation of a homebuyer’s credit history. Simplified, it is an equation which mathematically weights selected components of a homebuyer’s credit history and present financial circumstances to arrive at a number — the score — which is meant to gauge the homebuyer’s likelihood of repaying debt.

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

• one reportable account (credit card, loan, bank account, etc.) at least six months old; or
• one reportable account which has been reported to FICO in the last six months; and
• no report on record that the homebuyer is deceased.

Editor’s note — A homebuyer gets no credit for making timely payments on rent, utilities or cell phone bills, but he is penalized for failing to make payments on them. FICO scores do not reflect a homebuyer’s positive payment history of such accounts, nor are they alone sufficient to establish a FICO score. However, when such bills are delinquent, they may be reported to the bureaus by those creditors as delinquencies. If the accounts go into collection or become so delinquent a judgment is recorded against the homebuyer, they have an adverse effect on a homebuyer’s credit score.

After the six-month credit building period to establish a score has passed, the homebuyer’s credit behavior is further assessed, and a score is assigned according to his credit behavior known to FICO. The FICO score range is from 300-850. Theoretically, the higher the score, the more likely a homebuyer is to repay his debts. As credit scores are based on a homebuyer’s history of credit use, no use of credit means no score exists.

A FICO score consists of five components based on debts reported to FICO, weighted as follows:

• 35% is 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 they occurred;
• 30% is amounts owed, including the number of accounts with balances, and the proportion of credit lines used or installment loan balances outstanding;
• 15% is length of credit history, including time since an account was opened and time since there was activity on the account;
• 10% is 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 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 — Experian, Transunion and Equifax. 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 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 real costs of FICO scoring during the Great Recession

Media reports often overstate the FICO score impact of a homeowner’s decision to walk away and other negative aftershocks of the Great Recession, the inclusive housing bust and the accompanying financial crisis. All sorts of would-be pundits bandy about numbers as high as 200-300 points off for a foreclosure.  Self-proclaimed “experts” are dragged into the mix to give their opinions on how a homeowner might fare credit-wise when facing foreclosure or contemplating his enforceable walkaway option.

The cacophony of opinions from uninformed sources confuses homebuyers and keeps them in an uninformed state, a corruptive phenomenon referred to as asymmetry of information — industry information that the buyer is not aware of and does not have access to, and if he did, would impact his mortgage decisions.  Thus, as gatekeepers of real estate, it’s up to brokers and agents to help prospective homebuyers and owners weed through the compounded misinformation to gain the knowledge they need to make their housing and mortgage decisions -  all part of a licensee’s obligation to a client.

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 credit ding. These numbers are elusive since they are given in a range, and the ranges vary greatly as they are highly dependent on a homebuyer’s current credit score. FICO’s scoring method is thus numerically inconsistent as it penalizes homebuyers with higher credit scores more than those with lower credit scores for negative events.

Figure 1

_{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 homebuyer’s entire credit makeup to arrive 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 a foreclosure is only based on that event, and does not include the dings for the inherent delinquencies or loan modifications leading up to the foreclosure. This gives the clearest picture available to those considering their options for resolving their mortgage problems.

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

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Copyright © 2010 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 20069, Riverside, CA 92516.