FICO - Blessing or Curse?

As you probably know, FICO credit scores are well entrenched in the mortgage industry. The lower your score, the less likely you are to be approved, and the more likely you are to pay a higher interest rate. Understanding FICO scores is critically important to you.

Let's go back to basics. Fair Isaac Corporation originally developed its credit scoring system for issuers of credit cards. If someone wanted to open an account and make a purchase, you wouldn't want to tell the customer to come back next week. You'd want to have a cheap and quick way of determining the creditworthiness of applicants.

These scores are commonly called FICO scores although each bureau has a different name for its version. TransUnion calls their score Empirica, Equifax calls theirs Beacon, and Experian uses the FICO terminology. I am led to believe that the systems are identical, but that the scores vary because of the slight differences in data reported to each agency.

It has taken the industry a few years to get used to what these scores really mean, and it has not been all that rational. For example, the scoring system was not developed for the mortgage industry. Remember, it was developed for credit card issuers. The Fair Isaac people tell me that they offered to come up with a scoring system that would predict the credit performance of mortgage applicants, but the industry said they weren't interested. Hmmmmm!

So we blithely go along assuming that people's performance history with credit cards is likely to be identical to their future mortgage performance. To me that is a preposterous assumption. The foreclosure rate generally hovers just over 1 percent. That means that the industry's underwriting guidelines are correct 99 percent of the time. Not bad Quality Control! What is interesting is that the foreclosure rate is very low in areas where the real estate market is good and is higher where the market is soft.

This should come as no surprise. When someone is facing foreclosure in a hot market, he sells and pays off the mortgage. No more problem. In those areas where someone would likely take a loss upon sale, I suppose they look at it like they might as well stay in the home rent-free for as long as they can.

I want to be supremely logical in my line of reasoning, and make sure I connect all the dots correctly. Where I'm going with this is that it seems as if the likelihood of a loan going into foreclosure is far more dependent upon where the property is than what the borrowers' credit scores are. If that's the case, why all the booshwa about credit scores? Indeed!

I think that the reason for this is that credit scores are easy to measure. In a bureaucratic industry like we have coming up with a system that "sounds good" is easier than one that "is good." Telling everyone that you have a "risk-based pricing system" sounds pretty good, in spite of the fact that they have no meaning as predictor of performance.

On the good side, the automated underwriting systems used by FannieMae and FreddieMac seem not to be based upon scores. They want to know the scores but I think that their evaluation systems seem to be more lenient. When they have other good qualities, we get loans approved for people who have pretty low FICO scores.

When it comes to pricing, however, it's a different story. Increasingly, there are incentives for good scores and pricing penalties for poorer scores. We just had a borrower with a 667 score and she had to pay a .125 point penalty because her score was below 680. On a $540,000 loan, that .125 point cost her $675. As it was, we were able to get her a very good deal, and the .125 point was offset by the fact that her rate was .25 percent lower than market. But not everyone is that lucky.

Here are some common pricing systems:

Lender A - >700        .125 point better

Lender B - 620-660    .5 point worse

                720-779    .125 point better

                >780        .25 point better

Lender C   <680       .125 point worse

You get the picture. The bottom line is that in the future there won't be good scores or bad scores. There will just be rewards and penalties for how your score compares with the lender's criteria. In fact, you just might go with one lender versus another because of this factor. But you'd have to ask about it when you do your research.

Be very careful out there.