To make loan analysis more effective, objective, and programmable, the system of credit scoring was developed by collecting and statistically analyzing data on mortgage applicants in the past. Various characteristics of borrowers that might affect how well they handle debt are combined with different features of their credit history to statistically explain what makes some borrowers default on their loans. The factors found to predict default are given numerical weights and a formula is devised to calculate an overall score. The higher the score, the less likely the borrower will default. Lenders may use a specific minimum score to decide whether to make the loan. In some cases, the lender will still approve a loan to someone with a low score, but it will come with less favorable loan terms. For example, so- called “sub prime” loans may have higher interest rates and lower maximum loan-to-value ratios.
There are various systems in use, so if you think your score will be marginal, you might submit an application to more than one lender or apply elsewhere if you are turned down the first time. Some lenders’ systems may be more lenient, emphasize different factors, or permit the lender to make loans to less than prime credit scores. Other lenders may offer you their most favorable terms but require more mortgage insurance coverage. The price of this increased coverage is a higher insurance premium (generally added to the monthly payment). Also, credit scoring systems change over time as more data is used to compute and refine the formulas, so you may get a higher score at a later time even though you did not make the cut earlier.
Here are some factors that figure into an applicant’s credit score:
Past history of delinquency and default on financial obligations. You may be allowed a mistake or lapse during a time of financial difficulty, but if a lack of timely payment appears habitual, expect to be downgraded severely.
High-debt lifestyle. If you use much or all of the credit line you are allowed on credit cards or, if you carry a lot of debt relative to your income, the system will deduct points.
Length of credit history. The fact that you have a long history of meeting your obligations is important.
How often credit is applied for. This is a consideration most people do not understand. However, lenders discovered that one sign of future trouble is a borrower who opens many credit accounts, particularly over a short period of time. That person may be trying to juggle a high debt burden by using one account to pay off another or is on a spending spree in advance of filing for bankruptcy.
The way these factors are weighted changes over time. New data is compiled and the way borrowers behave changes so that the systems evolve and improve. Also, lenders use the score in conjunction with other information and considerations, such as the down payment on the loan, the income-to-loan ratios (see Key 18, “Loan Qualifying”), and the applicant’s length of time at their current job. For credit scoring (and the automated loan underwriting that is becoming more prevalent), these considerations must be in a form that can be expressed numerically, i.e., not based on the applicant’s sex or ethnic characteristics. Nor do they depend on income, per se. Fannie Mae found that many applicants with low-to-moderate income have higher credit scores than those with higher incomes. Therefore, use of credit scoring promises to make mortgage lending more equitable.
Because your score is based on your history of using credit, there is no quick fix to a low credit score (beware of those who offer to raise your score for a fee). However, you may improve your score gradually by consistently using credit responsibly. In fact, it may be advisable to take a sub-prime loan and buy a less expensive home. In that way, you can demonstrate you are a good risk even though your present score does not agree. After a few years, you will be armed with a better score, and you can apply for a loan with a lower interest rate. |
