Legal Realtor - What’s the ‘Score?’ Understanding Credit and Lending Risks

by ROBERT S. KUTNER, ESQ. Partner, Casner & Edwards | Apr 27, 2016
The 2015 movie, The Big Short, highlighted bank abuses that led to the financial crisis of 2008. Loans had been issued to numerous borrowers with little regard to annual income or creditworthiness.
The loans were packaged in groups and sold. Since 2008, lenders have become extremely sensitive to the risks they undertake when lending. Consequently, they have tightened their standards when evaluating the creditworthiness of borrowers, relying on mathematical formulae, namely credit scores, for making lending decisions.  

Some prospective homebuyers who have applied for financing with the belief that they would be approved at the lowest advertised interest rate have been surprised when advised they only qualify at a higher rate. The explanation is not necessarily based on the borrower’s income or the loan-to-value ratio for a property, but lies with the murky topic of a consumer’s credit score. Most borrowers should determine their credit scores before applying for a loan and take steps to eliminate factors that reduce their credit scores. 

“Fair Isaac”:

Credit scoring is a method for providing a snapshot of a borrower’s credit risk at a particular point in time by applying a mathematical formula to a borrower’s credit history to produce a three-digit numerical score that is intended to identify the risk that the borrower will fail to repay a loan. The most widely used credit scores are those developed by Fair Isaac Corporation and are commonly known as 
“FICO®” scores. 

Fair Isaac was founded in 1956. Its purpose is to assist lenders to manage credit accounts, to detect credit fraud, and to automate business decisions. The benefit 
of FICO® scores is that they can be delivered almost immediately, helping lenders process loans and speed approvals. It is estimated that FICO® scores are obtained by lenders for more than 75 percent of mortgage loans.

FICO® scores range from 300 to 850 (Experian). They vary slightly among the other major credit report agencies: TransUnion (309-839) and Equifax (334-818). According to FICO®, there are five factors that are used to determine a consumer’s score: 

  • Payment history accounts for 35 percent of one’s score; 
  • The amounts owed comprise 30 percent; 
  • The length of credit history is 15 percent; 
  • Newly opened accounts and inquiries amount to 10 percent; and 
  • The “mix” of credit cards, retail accounts, installment loans and mortgage loans determines the final 10 percent. 
Know The Factors:

The factors that affect a consumer’s score the most are late or missed payments and credit use (the ratio of how much credit is being used compared to the total amount of credit that is available). Length of credit history also affects the credit score, so it makes sense for a consumer to keep your oldest accounts open unless there is a compelling reason to close them. Negative remarks (like a late payment or accounts in collections) stay on one’s credit report for seven years.

FICO® scores exclude: the borrower’s age, race, color, religion, national origin, and marital status. They also exclude where the borrower lives, the borrower’s salary, occupation, employment history, rental agreements, child support obligations, and interest rates on particular accounts. Most consumers fall within the 600 to 700 range. 

  • A score of 720 or above is often considered excellent credit; 
  • 680-719 is good; 
  •  For scores 620-679 lenders generally take a closer look at the consumer’s file; 
  •  585-619 puts one at higher risk and generally makes one ineligible for the best rates; and 
  • A score of 584 or below makes lenders question whether to make credit available. 
  • The exact numerical range for each category is determined by the lender.
Lenders may purchase FICO® scores from each of the three major reporting agencies – Equifax, Experian (formerly TRW) and TransUnion. The numerical scores from each agency may vary by as many as 50 points. The primary reason for the variation is that the financial information received by each agency differs. While the credit reporting bureau controls the data, FICO® controls the scoring formula. For example, one consumer reported falling just short of the score needed to qualify for the best rate. He went to another lender that used a slightly different formula and was able to obtain a loan that generated savings of more than $20,000 over the life of the loan.

With regard to payment history, FICO® reports that it considers the frequency of late payments as well as their length and recency. For example, a 30-day late payment last month will carry greater weight than a 90-day late payment five years ago. When factoring in the amounts owed, the FICO® formula considers the amount owed, even if paid in full every month. It also includes how many accounts have balances, what type of loans (for example, installment or revolving credit) have balances and the percentage of the original loan that has been repaid. Paying down installment loans is a good sign. 

Generally, the longer the credit history, the better the score. Taking on new credit can adversely affect one’s score. However, the FICO® formula distinguishes between opening new accounts and merely interest rate shopping. Rate shopping is generally not associated with a higher risk of default. Finally, the score for one’s account “mix” is affected by the kinds of credit accounts one has and the number of each. It varies for consumers with different credit profiles.

The Law:

By federal law, every consumer may obtain their credit score once each year from each of the three major credit reporting agencies: Experian, TransUnion, and Equifax. If a large loan is to be obtained, all three scores may be obtained simultaneously at web sites such as www.AnnualCreditReport.com. A free credit report and score is also available at www.experian.com and a 30 day free trial of a credit monitoring product that includes one’s credit score is offered at www. fico.com and at www.transunion. com. To guard against fraud protection, a consumer may request one report every four months. By doing this, erroneous financial and background information can be corrected before it becomes an obstacle to financing. 

Free monthly credit scores may also be obtained online at various web sites, including www. CreditSesame.com and www.CreditKarma.com. However, care must be taken when providing social security numbers and other personal information, since the internet carries a substantial risk of fraud.

Also under current federal laws (the Fair Credit Reporting Act and the Equal Credit Opportunity Act) when a consumer’s application for credit is rejected, the consumer must be provided the reason for the rejection within 30 days. Historically, consumers have been kept in the dark about their credit scores. It is recommended that before a prospective buyer begins the process of searching for a home, they check their credit report at each of the three reporting agencies. 

Improving the Score:

To obtain a better score, borrowers should pay bills on time. Simply closing an account in which a payment was missed will not eliminate it from a credit report. It is also recommended that the borrower pay off debt, rather than moving it around. Unused credit cards should not be closed, since having fewer cards may lower one’s score. Finally, avoid opening several new accounts within a short period of time, since this will lower one’s score.

With education about the factors used to formulate their credit scores, consumers can put themselves in the best position to obtain the best financing rates.