Anyone who has bought a home can attest to the stress caused by the loan approval process. Once the closing is over, most purchasers feel a huge sense of relief. Often, the stress release of the closing finally taking place exceeds the joy of home-ownership itself. Understanding how your credit score impacts the loans available to you, as well as the interest rate you may receive, is one way for you to minimize the stress of the home buying process.
Understanding that today’s economy and the elimination of “no income verification”, “stated income” and other “liar loans” have left most borrowers with only one option: the “full-doc” show your income taxes, bank statements and proof of employment to the lender loan! In recent years, even those with great credit and verifiable income opted for the stated-income/stated-asset or no income verification loans because most people wanted to avoid the tremendous inquiry and scrutiny of the full-doc loan.
Basically, your credit score determines whether or not you will get approved and whether or not you will qualify for the best rate of interest if you are approved. In fact, the better your credit score, typically, the better the rate you will qualify for. However, every lender has its own definition of “excellent credit”, although currently, most lenders adopt Fannie Mae and Freddie Mac guidelines as to what scores are attributed what ranking. Some call it A credit, A-, etc., while others in the industry call it Excellent, Good, Fair, Poor. For borrowing purposes, consumers are issued scores by a computer that uses a credit risk model based on thousands of credit histories.
Credit scoring was adopted as a means for lenders to simplify the borrowing process. Lenders wanted to reduce the cost and risk of lawsuits associated with discrimination based loan denials. Now, lenders deny based upon your credit score. If your score is 550 and you are denied credit, you cannot argue that the computer denied you based on your race, religion, or any other reason. Additionally, the Fair Isaac company standard, commonly referred to as FICO scores, eliminated any personal involvement in the loan denial process. People can now say “you were denied based on your credit scores” and you cannot sue anyone. The Fair Isaac model was the first widely accepted credit scoring model used. Your credit scores can range from 350 to 850. Much like a Band-Aid describes the bandage applied to a cut, FICO is used to describe your credit score today. The higher your FICO scores, the better credit risk you are believed to be.
Generally, any score above 720 is currently thought to be excellent, although some lenders require a minimum of 740 to qualify for their best interest rates. During the subprime mortgage boom, it was not uncommon for people with scores of 680 or above to get the same rates as someone with a score of 780. Currently, a credit score of 680 and above is categorized as good, with 650 or more being fair. Scores below 650 will be charged extra percentage fees (rate hits to mortgage lenders). This means that if there is a 0.75% rate hit for having a 620 credit score, that if the best rate available is 5.00%, that the lowest rate someone with a 620 score will receive is 5.75, or 0.75% above the best rate.
By the early 1990’s, Fannie Mae, (FNMA) required a minimum credit score of 620 on all loans that lenders would submit to it for purchase. In order to create liquidity in the market, the Government created FNMA and Freddie Mac (Freddie) to purchase loans from lenders in what is now known as the secondary market. Thus, if you apply for a loan, most banks will follow the requirements of these agencies in approving/denying your loan application. A lender is not likely to approve your loan unless you qualify pursuant to FNMA (or Freddie) guidelines, ensuring for the lender that they can sell your loan to FNMA (or Freddie). Any loan that was not FNMA conforming would be harder to sell on the secondary market. Thus, that borrower would receive a higher interest rate. A further analysis may help you understand how it all works.
Fifty years ago, if you applied to Your Town Savings Bank for a mortgage loan, they would review your income, assets, expenses, and employment history. If everything checked out, they would give you a loan. Every month you made your payment, you would send the check to your lender and they would adjust your account accordingly. In the 1970’s, the government decided that more liquidity was needed in the marketplace. FNMA was created. Basically, now when you applied, your lender would approve your mortgage, and then sell your mortgage loan to FNMA. Your lender would then take the money they received and make more loans.
To make matters a little more complex, mortgages began to be sold in the secondary market as Mortgage Backed Securities. Instead of simply selling your loan to FNMA, these loans were packaged together with other loans and sold to investors. Rather than receiving monthly payments, the investors would often get paid twice a year, much like investors that purchase government bonds. The monthly payments would be received by a “servicer”, who would keep a portion as its fee and then pass on the balance when payments were due to the investors.
In FNMA’s desire to add liquidity to the market, lenders and investors were able to use this desire against the public and the government. When greedy investors and lenders were added to the mix, the desire for liquidity fueled the banking collapse of 2008. Basically, a mortgage was divided up and a portion of the mortgage might be pooled with many other mortgages to create a “mortgage backed security”.
This mortgage backed security was then sold like a bond to institutional investors, pension funds, municipal governments and others as an investment. To make matters worse, the scam was extended and the mortgage backed securities were transferred off the books of a bank (which would be subject to federal oversight) and into a collateralized debt obligation (“CDO”). A CDO is a fictional creation of savvy bankers.
These CDO’s would own millions of dollars, possibly hundreds of millions of dollars in mortgage backed securities. These CDO’s could operate in a way that banks never could, because they were unregulated. Who created these CDO’s? All the major lenders and investment banks. The subprime mortgages given to borrowers that had no credit or sometimes no job, were pooled with other mortgages into these CDO’s. However, one single mortgage could be spread across many CDO’s. These CDO’s were often given AAA ratings, the same rating as a United States Treasury Bond!
There are three major credit bureaus: Equifax, Experian, and Trans Union. Each credit bureau maintains a separate credit report on each individual with a credit score. Often, each bureau has different information in their reports. Your credit score can be different with each bureau because your credit score is based upon the information that each bureau has. Thus, since there are three separate credit reporting bureaus (often called agencies), there are also three separate credit scores. Equifax uses a score called Beacon, TransUnion’s score is called Empirica, and Experian uses the traditional FICO score. Depending on the information reported, a person’s score could vary, sometimes significantly, from one bureau to the next. It is not a rare occurrence to have a difference of 100 points from one bureau to the next.
The reason is that sometimes there is erroneous information in a file, other times one bureau could have a derogatory credit statement, such as three late payments, which are inexplicably missing from the other bureaus’ reports. For mortgage purposes, most lenders use your middle score. Thus, if you have scores of 620, 645 and 670, a lender will say your credit score is 645.
Credit scores are determined by using a mathematical calculation. In fact, it is so complex, that the actual scores are done by means of a computer program. Many of items are taken into account, including but not limited to, amount of credit lines currently available, current balances on accounts, number of late payments, amount of revolving accounts, amount of recent inquiries, length of time accounts have been established, and numerous other factors. The truth of the matter is that the bureaus have not disclosed the actual formula that each uses. Read More