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   ARTICLE   |   From Scotsman Guide Residential Edition   |   February 2008

What if We Killed the Credit Score?

The key to mitigating borrower risk could be in more detailed payment analysis

In the years that the mortgage industry has used credit-scoring as a tool to determine borrowers’ creditworthiness, or borrowers’ ability to pay back a mortgage, the industry has not experienced a market like this. Even the historical data used to create the scoring model does not date back to a market like this. Therein lies the problem.

In the 1980s, the mortgage industry began using credit scores uniformly as part of loan decisions. These scores were designed to determine the probability of a borrower having a 90-day late payment in the next 24 months on any account. Millions of credit profiles from borrowers across the country were used to compile these scoring models.

Credit scores removed a number of risk-determination factors from the underwriting process, which may have led to the disastrous default situation we are facing today.

On top of that, these scores are becoming out of date because they were not designed for a depreciating market. As an industry, it may be time to abandon the credit score and return to a more detailed risk-analysis system -- and at the least, safer loan programs.

What changed

Before credit-scoring, trained underwriters examined borrowers’ credit profiles objectively to determine borrowers’ financial strength and their ability to pay back mortgage debt. Underwriters established this by verifying borrowers’ assets, savings patterns, credit depth and increasing credit limits, as well as determining the probability of mortgage- payment “shock.” If borrowers didn’t have ever-increasing credit limits, which show a proven track record to pay back larger and larger debts, they were less likely to gain approval for maximum-financing loans.

Today, borrowers with three credit cards with a minimum of six months of activity and credit limits between $500 and $1,000 can have a credit score in the mid-700s. This allows borrowers to qualify for large loans without that track record of increasing credit limits.

Another previous practice was that borrowers with questionable savings patterns were considered higher risk and less likely to receive maximum financing. The philosophy was that these patterns often signaled that these borrowers were not prepared for the addition of mortgage payments.

With today’s models, underwriters look at debt-to-income ratios, but they typically look at gross income instead of net income. Therefore, they may not include the spending habits that could make that disposable income nonexistent -- something underwriters could determine from analyzing borrowers’ savings patterns.

What went wrong

Besides downplaying past risk indicators, the use of credit scores as the only risk-indicator for a loan applicant presents another danger for the industry. The data that went into the creation of the credit-scoring models didn’t fully consider what is happening in today’s market, with home-price depreciation and the increase in adjustable-rate mortgages.

A significant number of the borrowers defaulting on their loans had credit scores that ranged from the high 700s to the mid-to-low 500s at the time of origination. On the surface, those scores make the default rate among these borrowers fairly surprising. But many of these defaulting borrowers share two common denominators, which may have led to their current situation. They often have a loan at 100-percent or close to 100-percent loan to value (LTV), or they have an ARM that adjusted to a higher-interest-rate loan after two or three years.

Many of these borrowers with high credit scores were put into nonprime loans with an adjustable rate and interest-only payments because they needed some aspect of nonprime-underwriting guidelines for loan approval. Typically, they were stated-wage-earners or self-employed borrowers with stated assets. Programs were created to accommodate these borrowers, putting most of the weight of the underwriting decisions on the credit score and taking away the documentation traditionally used to evaluate risk. Because of these lax guidelines, more people could qualify for mortgages, which helped drive up property values to unprecedented levels. 

But now that home values are depreciating and adjustable-rate mortgages are reaching their reset points, many high- and low-credit-score borrowers are facing problems. They are either upside-down in their mortgages because of the depreciation or unable to make their mortgage payments because of the rate reset.

Adjusted rates and the effect of depreciating home values on high-LTV borrowers are factors that the late-payment-based model of credit-scoring cannot take into account. They have led to large number of defaults -- higher than any numbers from before lenders started using today’s credit-scoring system.

What’s ahead

By relying on a credit-scoring system that is only meant to predict the possibility of a borrower being 90 days late on any account in the next 24 months, we may have created a monster. But there is a solution: retiring these scores and returning to reviewing a variety of risk and compensating factors. The government already is recommending restrictions or removal of stated-income loans, which could also help to set the industry right.

If lenders do make an effort to remove credit scores from the loan-decision system, it will not be an easy process. It will require an increase in highly trained underwriters and less reliance on data processors and automated underwriting systems. But Wall Street is calling for tighter underwriting guidelines and standards’, continuing to use the scores and automated systems instead of trained underwriters will not tighten credit and underwriting guidelines.

There are steps brokers can take to stay ahead of risk. They can focus on originating full-doc, fixed-rate loans at less than 100-percent LTV. Brokers can also make sure that borrowers have reserves of their own and that their mortgage-payment shock is offset by their savings patterns. Above all, brokers should not put borrowers into mortgages that they cannot afford or cannot afford for the full term of the loan. Following these steps can also help brokers prepare for any government-regulated underwriting restrictions in the future.

•  •  •

It’s possible that depending on credit scores to make loan decisions has done this industry more harm than good. Credit scores may have acted as a catalyst for funding more 100-percent-LTV and stated-income loans, which played a role in driving up property values and default levels. The scores also have allowed for increasingly automated underwriting decisions, which at times cut out factors that lenders used to determine risk in the past.

With all of these negative side effects, it seems that an end to credit-scoring -- or at least a return to originating less-risky loans -- would be in everyone’s best interests. 


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